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Cboe Volatility Index (VIX) Explained

Cboe Volatility Index (VIX) Explained

Maybe you've heard of the VIX, or this thing called the fear gauge. What exactly is it? What is it telling us? How is it influenced? let me explain.

Cboe Volatility Index (VIX) Definition

Now the official title is the CBOE, which is the Chicago Board Options Exchange Volatility Index but yeah, the VIX. If you wanna sound cool, if you wanna sound like a trader, just people tell 'em that oh the VIX is doing this or the VIX is doing that, and that is what you're actually referring to. So what is this actually telling us? as I alluded to at the beginning, it is the fear gauge. 

Meaning it's pretty much-giving kind the market and everybody an insight into the feelings of the market. Are people feeling scared? Are people feeling anxious? Or are people just kind of not scared, everybody's feeling calm? So how does all this work? Well, let's just kind of walk through a little story here.

And let's say that Tom here, he believes you know what, his whole idea towards the market is you know what, I think the market is gonna be going down. So that is his thought, market, I don't know if that shows up or not, let's try that again. There we go, so he thinks the market is gonna go down. I'll just, so that represents the market there. That is on its way down.

But because Tom cares about his money, Tom is gonna say okay, is there anything I can do to hedge my risk? To keep my risk under control? To kind of protect me? Is there anything I can do out there? If I think the markets gonna go down, or maybe not know, because nobody ever knows, but he believes, or he's a little worried about it going down.

Is there anything that he can do, can I do anything to maybe make my life a little bit easier? And yeah, there is. He could then go and use, and step into the world of options. Now options, I'm not gonna go down that rabbit hole, they're like stocks. They're a derivative out there, derivative just means they are based and derived from the price of something else.

But just realize that there's another vehicle out there called options. And he can use options, again, to help just alleviate, to help protect himself a little bit from the market going down. So what the VIX is telling us, is that what happens with the VIX is if enough people join Tom in thinking uh oh, I think the markets are going down, I'm getting a little shaky, uh oh, well okay is there anything I can do. Well yeah, everybody knows that options exist, well what's that gonna do? The more people that start to use these options because the markets gonna go down, that's gonna cause these option prices and stuff to expand and expand.

So in other words, people have to pay more from the options point of view in order to protect themselves. In order to protect against the risk. So, therefore, the VIX, when a lot of people, so let's just call it lots equal nervous. So when a lot of people are nervous that is gonna send the VIX higher and higher and higher. Because you have a lot of people that are nervous and they're gonna use options, and the more people that buy something, the more people that are using something, right that's just basics applied to man, the higher those prices are gonna go.

So therefore the VIX is gonna go up when a lot of people are nervous. And that's the exact opposite reason why if the VIX is down low, well then there's not a lot of Toms out there right? Tom, there's not many Toms, people aren't thinking that the markets going down, so, therefore, they don't feel like they need to protect themselves against anything, therefore they're not gonna be using options in that manner, and when a lot of people aren't using options in that manner, well those prices are gonna be very mild, therefore the VIX will be going down in those situations.

So that is how the VIX works, and what it's telling us, is it's telling us how many people are starting to protect themselves. How many people are getting a little anxious and nervous out there, and again fearful, hence the fear gauge, because they're not using options to do certain things within the options market.

 So the more Toms you have out there, that just means that the more the market is nervous and the more that the market is nervous, the more options are gonna be in play, and the more options that are in play, the higher prices and the higher it's gonna cost to protect yourselves, and that's what's gonna cause the VIX to go up.

So that's what the VIX is, that's how it works, that's how it's all influenced. So at the end of the day, the moral of the story is that the higher the VIX is, that just implies the more nervous people are out there as a market as a whole. The lower the VIX is, that just tells you people aren't very nervous, people aren't very scared, people just think hey, everything's perfectly fine, so that's what the VIX is telling us, and that's how it all works.

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