Updated: Feb 24, 2022
If you are into trading you would have heard about India VIX or S&P 500 VIX, if not then, VIX or the volatility index often called the fear index, gives us the expected returns the stock market could deliver in the next 30 days. VIX measures the volatility of an index. Generally, India VIX traded between 11 to 18 before covid, now it trades between 15 to 25. Here 25 on the India VIX implies that the stock market can go up or down by 25% in the next one month. VIX doesn't tell us the direction of the market but it tells us the intensity by which the market will probably move. A 25 on the VIX implies a 25% variation is expected in the stock market in the next one month. VIX goes up when the market is uncertain, and even when the market is moving up rapidly. VIX is calculated using the order books of out-of-the-money call and put options. Since it measures the expected returns from the stock market for the next one month, it has no limit theoretically, it can go up to 100 or even more. India VIX shot up to 83 in March 2020, which was the highest ever, here it implied that the variation in nifty could be 83% up or down, but depending on the situation it is upon the observers to decide which one, in this case, WHO had recently declared covid 19 as a pandemic, so the market would fall and not rise, so here 83 meant that there is a downside of 83%. The recent Russia Ukraine crisis has also resulted in the VIX shooting up. Therefore many traders use VIX as a hedge to mitigate the risk of uncertainties in the market. The losses in the equity markets can be recovered from buying VIX derivatives at the right time.
It is often dubbed as the fear index but it doesn't mean that the VIX goes up only when the market is crashing. As shown in the above graph in Jan 2014 the VIX moved up when the market was going up. As said earlier VIX doesn't give a direction but intensity of the variation. The variation could either be positive or negative. The S&P 500 VIX is calculated in real-time by CBOE(Chicago Board Options Exchange). So what does it mean to the trader, one, it gives a picture of the sentiments in the market in real-time, two, it can be used as a hedge against Volatility risk, three option traders heavily rely on the data given by the VIX to make their daily trades. How? As the rule of options trading goes, in a volatile market, option premiums are usually high and in a dull market, option premiums are low. So when there is more volatility ( when the VIX is higher), option premiums are likely to be overpriced. VIX above 18 is considered to be volatile, and options premiums will be high during this time, which makes a good opportunity for option sellers, and when the VIX is around 15 and signifies a dull market, option premiums are low and makes a good opportunity for option buyers.