THE VIX, also commonly called ‘the fear Index’, measures the implied volatility of the equities market over the next 30 days. It is administered by the Chicago Board Options Exchange (CBOE) and is based on a wide range of equities in the S&P 500.

When the VIX is low (typically less than 20) then the market is considered to be relatively stable, while when it is high (typically above 30) the market is expected to be volatile. The lower limit of the VIX is 0, though this is extremely unlikely as it implies that every investor has exactly the same expectation of the market. Theoretically the upper limit is infinite, though again this is extremely unlikely as it will indicate absolute chaos. Typical values are between 15 and 40.

The mechanics of calculation are less important than the implications though the fundamentals should be understood. Briefly the VIX is calculated using the volatilities of a wide range of options, both call and put, against equities in the S&P 500.

The Black-Scholes model for calculating option prices from first principles uses the ‘variance’ of the rate of return of the share price as one of its terms. This variance is historical, and needs to be modified against future projections. If however, a buyer and seller agree on an option price, we can work backwards and calculate the expected variance, which is the determinant of the volatility. The VIX is obtained averaging this volatility over a wide range of equities.

VIX measures implied or expected volatility, not any historical measure. It tells what people expect to happen, not what has happened. If a buyer and seller agree on an option price, the variance can be calculated (as discussed above). If they are both extremely confident on what the market will do in the next thirty days, neither will require a ‘premium’ to the calculated value: – the buyer will be confident that the share price will perform as per expectation, so will use a low variance. If, however, either buyer or seller lacks confidence in the market, they will require a premium on the option: – the buyer will want to pay to pay less for a call or more for a put than the theory suggests. This premium will then be translated into a higher variance or price volatility.

Higher volatility normally occurs when the market is at a turning point, and investors are unsure of the future direction. As there is no clear direction different investors with different expectations will act differently.

There is also a theory that higher volatility occurs when the market is falling (see the paper by John Summa below). Investors expect the market to rise, slow and steady. The VIX will then be low, as investors become complacent. With a falling market, many investors are unsure how to behave, causing uncertainty. Volatility, and the VIX will then rise. An example is the Eurozone debt crisis at the same time as the USA job crisis of August / September 2011. On the morning of 12th September the VIX changed from 38.52 to 42.15, a move of 9%. Clearly investors expect the market to fall.

Yahoo finance, gives the current value and movement of VIX. The growth statistic of 9% above was taken from here.

Bloomberg VIX: Bloomberg is another source, with a useful 1 year chart showing how the VIX averaged between 15 and 25 for the year prior to August 2011, then rose to between 30 and 45 in August, September.

Investopedia and VIX: Investopedia is an on-line guide to investments terminology

Getting a fix on market direction by John Summa PhD 10 Sep 2003 (An Internet article of that name on Investopedia 12 September 2011)