What is the VIX?

by Miranda Marquit on September 26, 2012

Often, investors hear about volatility in the markets, and the impact that this volatility is likely to have on investment performance. One of the most popular ways to measure volatility is the use of the VIX.

Brief History of the VIX

The VIX is an index that reflects volatility in the markets. The VIX does this by measuring options related to the S&P 500. The idea for an index measuring the volatility of financial instruments was first floated by two professors, Menachem Brenner and Dan Galai. They suggested the idea that volatility could be used as an investment in 1986, and even wrote papers about it.

However, the first real breakthrough in the idea of volatility as an investment came from the Chicago Board Options Exchange (CBOE) when it asked Robert Whaley to create a volatility index based on stock market options. The ticker symbol assigned to this index, which looks at presumed volatility for the next 30 days, is VIX.

Even though the VIX was introduced in 1993, it didn’t actually provide investors with much to do, other than use it as a gauge. The VIX is actually quoted in percentage points – not in dollars – and can offer information about some of the expected movements in the markets, since it is based on the broad S&P 500.

Investing in the VIX

The VIX is regularly calculated by the CBOE. At first, the VIX was just one more tool that investors could use to determine what might be coming in the markets. However, since 2004, there have been opportunities to trade based on the VIX. It is important to note, however, that you aren’t actually investing in the VIX when you use these instruments. Instead, you are investing in derivatives. The investments are based on the VIX, but you do not actually “own shares” in the VIX:

  • Futures contracts based on the VIX started trading in 2004. It’s possible to buy futures based on what you think the VIX will do.
  • In 2006, the ability to trade exchange-listed VIX options began.
  • It’s also possible to invest in exchange-traded funds and exchange-traded notes based on the VIX. There are increasing numbers of opportunities to take advantage of opportunities derived from the VIX performance.

It’s important to understand, though, that there are inherent risks associated with investing in VIX-related assets. You should have an understanding of how options and futures work before you start trading assets based on the VIX.

On the other hand, it’s also important to recognize that the VIX doesn’t just measure downside volatility. A high VIX doesn’t always mean that the volatility will result in losses. Rather, it can also mean volatility to the upside. It’s really about the potential for large movements in the markets. Before trading based on the VIX, it’s a good idea to get a solid handle on volatility, and its effects – good and bad – on the markets.

Using VIX-related assets in your investment portfolio can be one way to hedge against some of the dangers of the market. One of the biggest dangers is correlation. While we like to think that bonds and stocks always move opposite, and that shifting around can help, they often move together in times of stress. The VIX , when used properly in a portfolio, offers a way to take advantage of economic upheaval in a way that shifting back and forth between stocks and bonds can’t.

Carefully consider your options before investing in assets based on the VIX. Do your research. But, once you have learned about the VIX, you might find that you can use it to improve your overall portfolio performance.

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This post was written by...

– who has written 12 posts on Excess Return.

Miranda is a freelance contributor to several investing and personal finance web sites. She also writes for her own blog, Planting Money Seeds.

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