What Does The VIX Mean To Option Traders?

What Is the VIX?

The Chicago Board Options Exchange’s Volatility Index (known as the VIX) is an indicator that tells option traders whether options are currently cheap or expensive, relative to their normal values. This is an indication of whether it is a better time to be a buyer of options or a seller.

The VIX is calculated in real time based on the prices at which options on one particular underlying instrument, namely the Standard & Poor’s 500 Index, are trading.

A mathematical formula, derived from the Black Scholes option pricing model, translates the price at which an option is trading (which reflects the price at which people are willing to buy the option), into those buyers’ expected rate of change of the underlying asset. This expected rate of change is called the underlying asset’s implied volatility or IV. When the underlying asset we’re measuring is the S&P 500 index, then its IV has a special name – the VIX.

What Does Implied Volatility Tell Traders?

Implied volatility is expressed as an annual percentage of expected price change. A VIX of 20 means that S&P option buyers, on average, believe that the S&P index will move in the future at the annual rate of 20% per year. A VIX of 10 would mean that, collectively, they believe that it will move at the rate of only 10% per year. In the last 25 years, the VIX has ranged from a low of 9.5% to a high of over 90%; and spent most of that time in the range of 12% to 25%.

When option buyers believe that the S&P 500 is going to make a large move in the near future, they will be willing to pay high prices for its options. In that case we would see a high VIX reading, meaning S&P options are expensive. If they don’t think it will move much, then the VIX will be lower, meaning that options are cheap.

By the way, the direction people expect the index to move doesn’t matter – only the expected speed of that movement. If the index is expected to move fast, both puts and calls will be expensive (high VIX). When it is expected to move slowly, then both puts and calls will be cheap. When traders’ opinions change, then the VIX changes, reflecting the fact that options have become relatively cheaper or more expensive.

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