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Episode 116: How the Chicago Board Option Exchange (CBOE) Volatility Index (VIX) Works - YouTube
Channel: Alanis Business Academy
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Welcome to Alanis Business Academy.
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I'm Matt Alanis and this is How the VIX Works
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Due to market volatility, I thought it would
be helpful to cover the commonly used measure
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for gauging future expected market volatility.
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This measure is known as the Chicago Board
Options Exchange Volatility Index, commonly
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referred to simply by its ticker symbol VIX.
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So how does the VIX work?
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Commonly referred to as the investor fear
gauge, the VIX is constructed using implied
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volatilities of a wide range of S&P 500 options.
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As a way of producing a numerical value, the
VIX uses a mathematical formula to analyze
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the difference between the purchase of call
and put option prices.
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A call is a type of option contract that gives
the owner the right to purchase a specified
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number of a certain security at a set price
for an established period of time.
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Although the owner of the contract may exercise
their call option if they wish, they are under
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no obligation to do so.
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So here is how it works.
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Lets say that you purchase a call option to
purchase 100 shares XYZ Company at $100 over
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the next seven days.
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XYZ Company is currently trading at $95 per
share.
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If you exercised your call option now you
would be purchasing shares of XYZ Company
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for $100 apiece while their market value is
$95.
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So essentially you are losing $5 per share,
or $500 total if you purchase 100 shares.
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So unless its share price increases over $100
there is no reason for you to exercise your
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call option.
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But if XYZ Company appreciates to lets say
$105 per share, you can exercise your call
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option and purchase shares for $100 each.
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You can then turnaround and immediately sell
them for $105 per share, which is the market
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value, or you can simply put them in your
portfolio.
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Selling the securities immediately would yield
a $5 per share profit or $500 total assuming
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100 shares are purchased.
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Now the only reason that an investor would
by a call option is if they felt that the
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market was going to appreciate value.
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As a result, a greater number of call options
compared to put options will lower the numerical
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value of the VIX.
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Now a put is another type of option contract
that works in a similar fashion to a call.
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However, instead of having the option to purchase
a security, a put provides the owner with
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the right to sell a specified number of shares
at a specific price within a certain period
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of time.
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Think of a put option as like insurance on
your home or vehicle.
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Just like homeowners insurance and auto insurance,
a put option is meant to protect you in the
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case that your asset becomes damaged, or in
this case decreases in value significantly.
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If that does happen, you have a contract that
gives the right to sell the security at a
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higher than market value.
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For example, lets say that you purchase a
put option allowing you to acquire 100 shares
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of XYZ company at $100 per share for a seven
day period.
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All of a sudden the share price of XYZ Company
plummets from $105 to $90 per share.
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Because you are the owner of a put option,
you can exercise your option and sell your
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shares at $100 per share instead of the market
value of $90 per share, which would save you
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quite a bit of money.
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The only reason that an investor would purchase
a put option is if they expected a security
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to decrease in value and they either wanted
to protect their own investments or take advantage
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of investors who are not as vigilant.
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Taking into account the basic economic principle
of supply and demand, if investors purchase
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a larger number of call options the the premiums
or prices of those options will increase,
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which will result in a lower VIX.
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If investors purchase a larger number of put
options than the premiums of those options
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will increase, which will result in a higher
VIX.
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Although meaningless to some, this numerical
carries significant importance to investors.
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A score of greater than 30 communicates that
a greater amount of volatility is expected
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going forward and investors are overall more
fearful.
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A score of less than 20 communicates the expectation
of low risk and low market volatility in the
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future.
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At least thats the expectation.
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Due to the fact that the VIX is evaluating
calls and puts that are purchased based upon
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assumptions as well as expectations, the index
measures the expectation of volatility and
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not actual volatility itself.
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So as with anything, there is always a risk
of relying solely on one indicator to make
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investment decisions.
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This has been How the VIX Works?
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For access to additional videos be sure to
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Thanks for watching.
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