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The Market Volatility Index (VIX): How it Works

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The Market Volatility Index (VIX) was introduced in an academic paper by Professor Menachem Brenner and Professor Dan Galai in 1987, and published in the Financial Analyst Journals in 1989. The Index is also sometimes referred to as the Fear Index, or Fear Gauge. This is because it is used as an indicative decision made by market participants, who track it to determine the level of tension in the market.

High levels of the VIX indicate increased tension in the market, as traders seek to hedge against volatility, while low levels of VIX indicate that the traders are comfortable with the prevailing market trends. There are several instruments that track the VIX, and the most common ones are the Exchange Traded Notes (ETNs) and Exchange Traded Funds (ETFs).

The Market Volatility Index (VIX): How it Works

Additionally, the VIX can be used in foreign exchange currency trading (FOREX), as claimed by Saeed Amen of Nomura   Holdings Inc., in a report that tries to examine how the VIX can be used to hedge against foreign exchange risk. Saeed said, “we find that historically higher levels of VIX, negative slopes in the vol curve, lower risks and negative VIX futures basis are generally accompanied by weakness in currencies generally considered to be higher risk.”

The VIX index itself represents a weighted average of options on the S&P500 index; some of the VIX tracking ETNs are also mapped against the S&P500, and a good example is iPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX), which provides access to Equity markets volatility through CBOE  Volatility Index futures.

The Market Volatility Index (VIX): How it Works

It provides exposure to a daily rolling long position for the first & second month VIX futures contracts, reflecting on the implied volatility of the S&P 500 Index at various points along the projected volatility curve. It is one of the top 100 ETNs/ETFs by assets, and volume and the value of shares traded. Yesterday it closed at $11.43, down $0.08, or 0.70% decline from the previous close, while it remained unchanged during premarket periods as at the time of this writing. It has dropped more than $10 over the last six months, as it traded at $24.73 in June.

On the other hand, CBOE’s  NASDAQ 100 Voltility Index (NASDAQ:VXN), remained unchanged yesterday at $19.09, while VelocityShares Daily 2x VIX ST ETN (NYSE:TVIX) was down $0.07 from $2.61 per share to trade at $2.54. During premarket, TVIX was unchanged as at the time of this writing. The TVIX was part of a big fiasco earlier this year.

The VOLATILITY Index  S&P 500 (VIX), yesterday was up $0.51 per share, to trade at $17.98, from the previous close of $17.47. The Chicago Options Exchange based Volatility Index has declined significantly over the last two months, since closing at $24.06 in May.

Other ETNs that are usedf by traders to hedge against volatility in the markets include, iPath Inverse January 2021 S&P 500 VIX Short-Term Futures ETN (NYSE:IVO) designed to reflect the potential returns available through an unleveraged investment in short-term futures contracts on the CBOE Volatility Index; iPath Long Enhanced S&P 500 VIX Mid-Term Futures ETN (NYSE:VZZ), and UBS E-TRACS Daily Long-Short VIX ETN (NYSE:XVIX), among others.

The VIX hit its highest levels in the year 2008 at the peak of the financial crisis, indicating the nature of the market as investors sought to hedge against volatility in the market. Analysts say that high VIX designates good points of buying stock, as this is expected to usher in a bull period, while low VIX designates anticipated bear markets, or  stagnation.

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