Measuring the S&P 500 on the VIX
The composition of the VIX was changed in 2003. At that time, the CBOE created a “new” VIX by making two changes to the original version. First, options on the S&P 500 index were substituted for those on the S&P 100. The CBOE decided that the S&P 500 — a widely followed average commonly used by mutual funds as a benchmark to judge their performance results — was more representative of “the market” than the S&P 100.
The second change made by the CBOE was to increase the amount of options used in the calculation of the weighted average. It was thought that by expanding the number of options used to calculate the weighted average, the VIX in its newer form would provide a more accurate representation of the level of implied volatility currently existing among option premiums in the market.
All options used in the VIX calculation are either in the front month — i.e. the nearest month to expiration — or the second month. The reason the CBOE limits options to the two nearest months is because it is their goal for the VIX to estimate the implied volatility of what an at-the-money option on the S&P 500 would contain with 30 days left until expiration.
The VIX is quoted in terms of a number between 0 and 100 — and normally trades at the far lower end of that range.
That number represents the anticipated percentage movement — both up and down — in the S&P 500 index over the next 30 days. So, for example a VIX reading of 24 would mean that — based upon the implied volatility in the options on the S&P 500 index in the front and the second months — the index is expected to move within a range of 2% (the 24 VIX reading divided by 12 months) over the next 30 days.
So, why is the VIX important? For one, it provides you with a reasonable projection of the expected range within which the S&P 500 is likely to trade within the next month.Keep in mind that the VIX changes on a minute-by-minute basis, according to the ongoing changes in the implied volatility in the S&P 500’s nearest two months’ option premiums.
Therefore, the VIX — and hence the projection of the S&P 500’s trading range for the next month — is being constantly revised. Nevertheless, that projection — as gleaned from the latest VIX reading — is an accurate reflection of the attitude of traders and investors about current market conditions.
And that reflection of traders and investors’ attitudes is the heart of the VIX’s value. When you can correctly gauge market participants’ attitudes — and then use that information to anticipate likely future price action — you have acquired an additional edge in your efforts to make money in stocks.