A lightweight introduction to volatility
What is it?
The quality or state of being volatile: such as: a tendency to change quickly and unpredictably.
Merriam-Webster dictionary
We all know Gasoline is a volatile substance. We also know that Cooking oil, when heated, becomes more volatile. Yet it is still considerably less volatile than gasoline. We treat these two substances quite differently…cooking oil is usually inside the house, while gasoline outside (in addition to other precautions). Since we understand the difference in how volatile they can be, we handle them differently while continuing to utilize them to our benefit.
The same is true for the business world and in financial markets. By understanding volatility we can better manage our risk and hopefully improve our expected returns.
Volatility in Financial Markets
‘VIX’ sometimes referred to as the ‘fear index’ is a financial index that measures the expected volatility of the S&P500 index over the next 1 month period.
Wut?
This number basically measures how unpredictable the collective market expects things might get in the next month. For example, as we approach the December off season, the 1-month expected volatility might start reducing as general business activity slows down and a good chunk of active market participants are off for the holdiays.
Back to formal definitions – VIX is an index that is a measure of the markets’ expectation of the average volatility over the next 30 days. It is important to understand that it is NOT a measure of current volatility (but obviously related).
Other Considerations
The VIX index is calculated by the Chicago Board Options Exchange (CBOE) utilizing the option prices for the S&P500 index. Options are simply time-limited contracts that give the holder an option to buy/sell the underlying security (S&P500 index in this case) at a particular price.
The VIX index itself cannot be traded. But market participants can utilize derivatives to bet on the index (e.g. options, and futures). Since there are futures for the VIX, there exists a term structure that can be utilized for further understanding the market expectation of volatility.