Volatility and the VIX fear index

Volatility describes how much and how quickly prices move. The VIX, often called the fear index, is a widely quoted measure of how much movement the market expects in the S&P 500 over the coming month. It is useful context for risk, but it is easy to misread, and it says nothing about which direction prices will go.

What volatility is

In finance, volatility is usually measured as the standard deviation of returns, which is a statistical measure of how widely returns scatter around their average. It is generally expressed as an annual percentage.

Annualized volatility = Standard deviation of daily returns x square root of 252

The 252 is the approximate number of US trading days in a year. If a stock's daily returns have a standard deviation of 1%, its annualized volatility is about 1% x 15.9, or roughly 15.9%.

There are two main kinds:

• Historical (realized) volatility looks backward at how much prices actually moved.
• Implied volatility is derived from option prices and reflects what the market expects. Option prices depend heavily on expected volatility, which is explained in options basics.

What the VIX is

The VIX is published by Cboe. It was introduced in 1993, and its method was changed in 2003 to use S&P 500 index options. It combines the prices of a wide range of S&P 500 options with about 30 days to expiration and converts them into a single number, expressed in annualized percentage points. A VIX of 20 means option prices imply an annualized volatility of 20% for the S&P 500 over the next 30 days.

The VIX is not an investment you can buy directly. It is an index, though products exist that track VIX futures. Those products have their own costs and behavior, and they can differ greatly from the VIX itself.

Example (illustrative numbers)

To turn a VIX reading into an expected range, scale it to the time period:

Expected 1-standard-deviation move = VIX x square root (days / 365)

At a VIX of 20, the implied one-standard-deviation move over 30 days is 20% x the square root of 30/365, about 5.7%. If the S&P 500 stood at 5,000 (purely for illustration), that is a range of roughly 285 points either way. Over a single trading day the same reading implies about 20% / 15.9, or 1.3%.

Under a normal distribution, about two-thirds of outcomes should fall within one standard deviation. Actual markets have fatter tails: very large moves occur more often than a normal distribution suggests. The number is a guide to scale, not a boundary.

How to read it: rules of thumb

There are no official thresholds. These are common rough reference points.

The VIX closed above 80 at its extremes in late 2008 and in March 2020.

Several tendencies are worth knowing:

• It tends to rise when stocks fall, and falls when stocks rise steadily. This inverse relationship is why it is called a fear gauge. It is not a perfect relationship.
• Spikes are sharp, and declines are gradual. Fear tends to build fast and fade slowly.
• Implied volatility has on average run somewhat above the volatility that follows, because option sellers demand compensation for taking risk.
• It measures magnitude, not direction. A high reading says the market expects large moves, not that prices will fall.

Common mistakes

• Reading a low VIX as safety. Calm periods can end abruptly.
• Treating a high VIX as a buy signal or a sell signal. High readings have often occurred around sharp sell-offs, but timing a bottom from it is unreliable.
• Applying the VIX to a single stock. It covers the S&P 500 only. Individual stocks have their own volatility.
• Confusing volatility with risk. Volatility is one measure of risk, but a permanent loss of capital is a different thing. Drawdown, covered in drawdown and risk measures, looks at losses from a peak instead.

Volatility for individual stocks

A stock's sensitivity to market moves is captured by beta. Technical indicators measure recent price swings directly, such as average true range, which averages daily trading ranges, and Bollinger Bands, whose width expands and contracts with volatility. Low-volatility periods are sometimes followed by larger moves, but that is a tendency rather than a rule.

Where to see it on StocksXray

StocksXray works from prices and filings rather than options data. For stock-level volatility, use the price chart indicators on a stock page, and the Bollinger squeeze scanner, which lists stocks whose bands have narrowed to a period of unusually low volatility. Beta comes from Damodaran datasets used in the site's valuation models.

Key takeaways

• Volatility measures how widely prices move, and is usually expressed as an annualized standard deviation.
• The VIX is the market's implied 30-day volatility for the S&P 500, derived from option prices.
• A VIX reading can be scaled into an expected range, but real markets have larger tail moves than the math assumes.
• The VIX shows the expected size of moves, not their direction.