Since the financial crisis, the Cboe Volatility Index — also known as the VIX — has been considered an early warning signal for market distress. But how does it work? WSJ explains. Photo Composite: Tom McCarten for The Wall Street Journal.
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(cash register dings) - [Narrator] Here's the S&P 500 over the last year or so. It looks pretty choppy, but people who have been around it for a long time know it can get a lot choppier than this. Here's the same index in 2008 during the financial crisis. You can see, the swings were a lot bigger back then. Swings in stock prices are known as volatility. Before the market crashed in 2008, casual observers of the market weren't really paying attention to it, but they do know, and that's because of this, the VIX or the Cboe Volatility Index. The VIX shot up during the financial crisis. Since then, the VIX has been known as a warning signal for market distress, but how does it work? (rhythmic mallet percussion and orchestral music) (pleasant mallet percussion music) Like the name suggests, the VIX looks at volatility. Specifically, it takes data about option trading and uses it to forecast the likely size of coming market swings. When the VIX is high, it means traders are expecting a shaky market, and when it's low, it means they're expecting a relatively stable one. Options grant investors the right to buy or sell a stock within a specific timeframe at a stated price. They come in two types, calls and puts. Call options grant the right to buy a stock at a stated price within the chosen timeframe. Investors often buy them when they are confident that the stock will rise and want to lock in a lower price. Put options allow an investor to sell shares at a stated price within the chosen timeframe. Traders tend to buy them when they think stocks might decline and want to lock in a selling price ahead of that drop. Here's an example. Let's say an investor owns company shares valued at $100 each. If the investor thinks the stock might go down and wants to lock in earlier gains, they could purchase a put option that would give them the right to sell the shares for, say, $85 at a later date. The investor and the put seller make a deal. The investor pays a small premium to purchase the options. If the stock price drops below the strike price, in this case $85, the put seller must buy the stock for $85 a share. This helps limits the shareholders' losses. If the stock doesn't fall as low as $85 while the option is valid, the put expires worthless and the shareholder is out of the premium. This means the put seller made money on the deal. So what does this have to do with the VIX? The VIX is calculated based on the price of options on the S&P 500. When traders worry the market will fall or are betting it will rise, they can buy put or call options to protect their assets or make money. The increased demand drives up the price of these options which, in turn, drives up the VIX. So here's the VIX now and here it is in 2008. Right before Lehman Brothers collapsed, you can see, option prices were high. Investors, betting that the volatility would persist, were buying more calls and puts and driving up prices. Now, people who watch the markets keep their eye on the VIX, and as the VIX becomes a more popular way of gauging the stock market, investors have started betting on the VIX itself. (pleasant mallet percussion music)