What is the VIX Volatility Index? How to profit from using the VIX Index

The VIX Volatility Index is one of the most common indicators for measuring market sentiment. When the US Stock Market plummets, the VIX Index often rises sharply. You also hear news about investors who made huge profits by investing in the VIX Index.

So, what exactly is the VIX Volatility Index? How do investors observe the VIX to assess market risk and participate in profit opportunities? This article will answer these questions.

What is the VIX Volatility Index?

The official name of the VIX Volatility Index is Volatility Index, and it is referred to as 変動率指数 in Japanese. It was established by the Chicago Board Options Exchange (CBOE) in 1993 and is maintained on a daily basis. The VIX index measures how much market participants expect the volatility of the S&P 500 index to be over the next 30 trading days.

The higher the VIX index value, the greater the volatility expected by market participants, indicating a higher market risk. Conversely, the lower the VIX index value, the lower the expected volatility by market participants, suggesting that the market is relatively calm.

The VIX Volatility Index provides investors with a measure to quantify market risk and investor sentiment, holding an important position in the trading and investment fields. Since investors often use the VIX index to measure market risk, fear, or stress levels, this volatility index is also referred to as the “Fear Index.”

The calculation of the VIX index is based on the option prices of the S&P 500 index. The specific calculation formula is very complex and has been updated several times, but essentially it is based on the volatility of option prices. It is calculated by taking a weighted average of the prices of a set of call options and put options that meet certain conditions.

The VIX value fluctuates between 0 and 100, and its actual meaning can be interpreted as follows: If investors expect the S&P 500 index to fluctuate by an average of 1% per day over the next 30 days, the VIX will be around 20. If the VIX is 40, it corresponds to an expected fluctuation of 2%.

Based on past experience, the long-term average level of the VIX Volatility Index is around 20. When the VIX exceeds 30, it typically corresponds to significant market fluctuations due to risk, uncertainty, and investor risk aversion. When the VIX falls below 20, it usually corresponds to a relatively stable and low-stress market period.

The VIX Volatility Index serves as an indicator to measure market risk and sentiment, and it has a wide range of applications. This includes helping investors assess the current level of market risk, developing risk management strategies, and short-term speculation.

VIX Volatility Index and the Relationship with the Stock Market

There is a clear negative correlation between the VIX Volatility Index and the S&P 500 Index, meaning that the movements of the two are often opposite. As a guide for stock market investment, the VIX usually has the following functions:

Warning for specific events

The VIX index is very sensitive to the impact of specific events. When significant events occur or the market faces great uncertainty, the VIX index usually fluctuates sharply. Investors can observe changes in the VIX index to gauge the market's reaction and sentiment towards these events. For example, the release of economic data, political events, and financial crises can trigger sharp fluctuations in the VIX index, alerting investors to market risk.

Investment Strategy Guidance

The VIX index provides investors with guidance on several investment strategies. Typically, when the VIX index level is low, it indicates that the market is relatively stable, and investors may consider buying strategies or purchasing stocks during downturns. On the other hand, when the VIX index level is high, it may indicate that the market is unstable, and investors may consider adopting conservative strategies, reducing positions, or holding safe assets.

Selection of Hedge Tools

The VIX index can also serve as a reference for the selection of hedging tools. When the market anticipates an increase in volatility, hedging tools such as volatility derivatives (like VIX futures and VIX options) may provide a certain level of protective effect. Investors can choose whether to use these tools for hedging operations based on the level and changes of the VIX index.

It is important to emphasize that just because the VIX value is high does not necessarily mean that stock prices will fall. An increase in the VIX number indicates that investors expect significant volatility in the market, but it can be in either direction, up or down. The VIX number will only be low when investors do not anticipate a large one-way move and market sentiment is stable.

Furthermore, the VIX measures the volatility of the S&P 500 index. In many cases, the direction of volatility of the three major US stock indices tends to be relatively consistent, but it is important to note that the VIX does not serve as a perfect inverse indicator for the Dow Jones Industrial Average or the NASDAQ Composite Index.

Since its introduction in 1993, the VIX index has accumulated about 20 years of historical data, and some researchers have summarized the patterns indicated by the data. For example, when the VIX number rises sharply and the US Stock Market indices are on a downward trend, it usually signifies that the decline in the stock market is about to hit bottom. Conversely, when the VIX number stops falling from a low level and begins to rebound, while the stock market is on an upward trend, it typically indicates that the major indices may reverse. According to researchers' observations, the VIX acts as a synchronous indicator for buy signals, while it serves as a lagging indicator for sell signals.

Historical Data Analysis of the US VIX Volatility Index

Looking at the historical VIX data of the US Stock Market, the VIX index shows a phenomenon of sharp rise every time a crisis event occurs in the market. Below are the VIX values during different events:

1997 Asian Financial Crisis: 36.27 2001 US terrorist attacks: 42.66 2008 Financial Crisis: 79.13 2010 European Debt Crisis: 40.93 2018, 2019 US-China trade war: 30.11 2020 Novel Coronavirus Pandemic: 66.04

As mentioned above, during the Asian financial crisis in 1997, the September 11 attacks in the US in 2001, the financial crisis in 2008, the European debt crisis in 2010, the US-China trade war in 2018 and 2019, and the COVID-19 pandemic in 2020, the VIX value rose significantly, indicating that the market fell into a state of extreme panic. In particular, during the financial crisis in 2008, the VIX value rose to nearly 80.

Another interesting phenomenon is that, according to research, the VIX index tends to rise before the US presidential elections. On average, compared to the figures from 60 days before the election date in November, the VIX index is usually at a higher level on the US election day. This trend is not always observed, and the historical observation samples are also limited, but this relationship can be interpreted as investors hedging against the uncertainty brought about by potential political changes.

The VIX index stabilizes after the election and begins to show a downward trend, but if the ruling party changes, there is a possibility that the VIX index will rise further. Taking the 2008 US presidential election as an example, the VIX index nearly doubled from two months before the election date in November. After the results of the 2008 election were officially announced, the VIX continued to rise further. This was because the Democratic Party defeated the ruling Republican Party in this election.

The presidential election of 2000 also provides an example. The VIX index rose in the days following the election date and increased further after the market digested the fact that the Republican Party brought about policy changes in place of the Democratic Party. However, it is noteworthy that both the 2000 election and the 2008 election occurred before and after significant financial crises.

During the 2020 US presidential election, the VIX index exhibited a relatively typical pattern of rise followed by decline. After reaching a low level of 20.28 on August 11, 2020, the VIX index continued to rise, peaking at 41.16 on October 29. Subsequently, it plummeted significantly after the election date in November, showing an overall downward trend.

Historical Data Analysis of Taiwan VIX Volatility Index

The Taiwanese stock market also has the Taiwan VIX (TAIWAN VIX). This index was calculated and edited by the Taiwan Futures Exchange in 2006, based on the Taiwan index options, following the calculation formula for the volatility index developed by the Chicago Board Options Exchange.

Taiwan is a typical outward-oriented economy, and due to the high level of economic liberalization and internationalization, the performance of Taiwan's stock market is significantly influenced by external factors such as international politics, economics, and finance. In particular, there is a strong positive correlation with the US economy. Therefore, looking at past situations, significant fluctuations in the Taiwan stock market and Taiwan VIX were often associated with external factors.

Looking at the data from the past few years, the Taiwan VIX has exceeded 30 three times, with the highest value recorded during the period of the pandemic in 2020 when it was rampant worldwide.

On March 23, 2020, the Taiwan Stock Market plummeted by 344 points to 8,900 points, and the Taiwan VIX rose to a peak of 57. At that time, the spread of the novel coronavirus was continuing worldwide, causing turmoil in the global financial markets. Subsequently, in May 2021, the pandemic worsened in the Taiwan region, and the Taiwan Stock Market crashed again, with the Taiwan VIX reaching a high level close to 40.

Before that, the Taiwan VIX exceeded 30 on February 6, 2018. At that time, the plummet of the US Stock Market triggered panic emotions, causing the Taiwan Stock Market to drop by 645 points at one point, ranking 6th in the history of significant declines in the Taiwan Stock Market. The Taiwan VIX rose sharply until it exceeded 30.

Since 2023, the Taiwan Stock Market has begun a stable recovery after the pandemic, and the Taiwan VIX has fluctuated between 10 and 20 for most of the time.

How to invest in VIX Volatility Index-related products?

Since the introduction of the VIX, this index has gained significant attention for quite some time, but it was not possible to trade it. The limited related financial derivatives were primarily used by banks, hedge funds, and other institutional investors. It was not until 2004 that the Chicago Board Options Exchange introduced VIX futures, and two years later, VIX options were introduced, allowing VIX-related financial products to be traded on exchanges.

Currently, there are the following products related to VIX in the market:

(1) VIX Futures: With VIX Futures contracts, investors can exchange the VIX index at a specific price on a certain future date. Based on their own assessment of the market Volatility over a certain future period, investors use VIX Futures to respond to changes in market Volatility.