Back to Basics: The Volatility Index

In 1993 the Chicago Board Options Exchange introduced the CBOE Market Volatility Index, also known as the VIX, which measures the volatility of the U.S. equity market. It provides investors with up-to-the-minute market estimates of expected volatility by using real-time S&P 100 index option bid/ask quotes.

The VIX is calculated by averaging S&P 100 stock-index at-the-money put and call implied volatilities. The availability of the index enables investors to make more informed investment decisions. Going over the VIX's history along with the S&P 100, or OEX, you can see that all of the spikes in volatility accompanied market downturns and significant events that affected the market.

This history reveals a great deal about the relationship between the market and volatility. The VIX has a definite tendency to spike upward during market declines. For example, during the major market decline of October 1987, volatility reached very high levels. That spike was the result of the sharp one-day market correction in October. Volatility then declined steadily until late 1989.

Another sharp increase in volatility occurred in August and September 1990, when Iraq invaded Kuwait. In January 1991, volatility rose sharply again, just before the U.S.-led initiative known as Operation Desert Storm. Another peak in volatility reflected the market's downturn, which occurred one month before the U.S. presidential election in November 1992. ...