Before looking at various volatility indices, let’s take a moment to define volatility. A textbook definition for volatility is a statistical measure of the dispersion of returns for a given security of market index. Volatility may be measured by using the standard deviation or variance between returns from the security or market index. The common rule is the higher the volatility, the riskier the security.

Simply put, volatility refers to the uncertainty or risk about the size of changes in a security’s value. Higher volatility means that the security’s price can potentially be spread over a larger range of values, leading to dramatic changes in either direction over a short time. On the other hand, lower volatility signals that a security’s value does not fluctuate dramatically, but is a steady gainer or loser.

Two Types of Volatility

There are 2 different measures of volatility to consider when approaching a volatility index:

 

• Historical Volatility (HV) - HV is a statistical measurement of a stock's past price movement during a specific time period. Generally, HV is calculated by determining the average deviation from the average price of a financial instrument in the given time period. Stocks with a high historical volatility usually require a higher risk tolerance.
• Implied Volatility (IV) - IV is the estimated volatility of an underlying security's price. It also helps determine the option's price. Since all other factors in the options pricing model are assumed to be known, the implied volatility is calculated last as a plug-in factor after other options pricing components are taken into account. In essence, implied volatilities are driven by market expectations of the underlying stock.

  Options traders can utilize both HV and IV to determine if a particular option is more or less expensive compared to prior time periods. Specifically, if an option's IV is higher than its HV, it is considered more expensive compared to historical prices. Contrarily, if an option's HV is higher than its IV, it is considered less expensive compared to historical prices.

 

There are 4 widely followed volatility indices, all operated by the Chicago Board Options Exchange (CBOE). Each volatility index corresponds to 1 of the major market indices: the S&P 500 Index (VIX), S&P 100 Index (VXO), the Dow Jones Industrial Average (VXD), and the Nasdaq 100 (VXN).

CBOE S&P 500 Volatility Index (VIX)

The VIX shows the market’s expectation for 30-day volatility for the S&P 500 Index (SPX). The VIX is constructed using the implied volatilities of a wide range of SPX options. The volatility is supposed to be forward facing and is calculated from both calls and puts. You may hear the VIX referred to as the “investor fear gauge.”

VIX values greater than 30 are associated with a large amount of volatility, while values below 20 are associated with less stressful (even complacent) market periods.

CBOE S&P 100 Volatility Index (VXO)

The VIX shows the market’s expectation for 30-day volatility for the S&P 100 Index (OEX). The VIX is constructed using the implied volatilities of a wide range of OEX options. The volatility is supposed to be forward facing and is calculated from both calls and puts.

CBOE Nasdaq 100 Volatility Index (VXN)

The VXN shows the market’s expectation for 30-day volatility for the Nasdaq 100 (NDX). The VXN is calculated the same way the VIX is calculated, but it represents the implied volatility for the NDX.

CBOE Dow Jones Industrial Average Volatility Index (VXD)

The VXD is simply the volatility index that tracks the Dow Jones Industrial Average (DJIA).