DATE: April 15, 2013
Can you explain the significance of Index and Equity VIX levels?
There are six inputs to the Black-Scholes options pricing model, stock price, strike price, time to expiration, interest rate, dividends and volatility. The first five inputs are known, but volatility is unknown. Consequently, if you take the market price of an option and the five known inputs, the Black-Scholes option pricing model can be used to solve for the "volatility in an option's market price." This is known as the implied volatility, and it is determined in the market by the forces of supply and demand.
Implied volatility is "the market's" estimate of what the volatility of the stock price will be between now and the expiration date. In mathematical terms, volatility is the annual standard deviation of stock price change, but the annual percentage can be converted to any period of time. Essentially, volatility is a measure of the potential price range of a stock over the time period.
But how would you determine which volatility level is most representative of the expected stock range over a period of time? Is it the implied volatility of the at-the-money options? Is it the implied volatility of the in-the-money or out-of-the-money options? In an attempt to answer these questions, the CBOE introduced VIX®, the CBOE Volatility Index, which is an index of implied volatility of options on the S&P 500 Stock Index. The VIX calculation uses front month and second month options with at least 8 days left to expiration and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index.
This same methodology used to calculate VIX is also used to compute volatility levels of various international indexes, several commodity-based Exchange Traded Funds, and five single stocks. The "VIX calculation" for an individual stock is intended to provide a consistent measure of implied volatility, which can be used by traders to estimate the standard deviation - or stock price range - anticipated by the market.