VIX - CBOE Volatility Index

A measure of market volatility, commonly used to calculate the values of stock options.

You’d think it’d be a measure of political arguments at Thanksgiving, right? But it’s not. Even if it should be.

The Volatility Index, or VIX (no relation to the Vapo Rub), is a measure of "market volatility," using sophisticated statistical measures. But, in essence, the VIX is a reflection of expected options volatility, because the elements that comprise it come from current market prices of options on a variety of indices. That is, things like calls on NASDAQ's changes, ticker: QQQQ, puts on the Russell 2000, etc...way out-of-the-money calls and puts on the S&P 500. Stuff like that.

The VIX was created in 1993 by the Chicago Board of Options Exchange to make the management of hedging all the more liquid, easy, and, well…lucrative. The easier the indices are to use, the more liquid the system and the more options contracts that get traded.

So…more money for everyone, right? Um, yeah. Not so much. More money for professional options traders. Less money for cardiologists trying to be smarter than Goldman Sachs’ finest.

The backdrop here is that the VIX is the key driver in the pricing of options. That is, the more volatile the market, the more valuable options become in hedging positions, i.e. playing investment defense. Why do they become more valuable? Take a stock trading at $40, with modest volatility, such that, in the last year, it has traded as high as $45 and as low as $35. A call option with a strike price of $47.50 would probably be pretty cheap. And remember that a stock price is kind of like a floating piece of cork in the ocean that has absorbed a lot of water. That is, in a calm sea, the cork can drop a couple feet in the water and a fish can pop it up into the air a few feet, and it will kind of trade on its own. But in rough seas, i.e. a volatile overall market, that cork will not only go up and down the 2 feet it travels on its own, but will be market-multiplied by some meaningful factor.

So if you take this very modestly volatile stock, and then place it in a high-VIX market volatile environment...all of a sudden, the odds that that stock could trade above $47.50 for some period of time, making that option more than worth a penny or two, suddenly gets very real, and the pricing of those options immediately adjusts to that climate.

So think about the VIX as the ocean, because it represents the overall volatility of the market itself. It then plays into the pricing of options, or pieces of cork, floating in the waves.