Thread by @SahilBloom

With the market volatility, you’re going to hear a lot about the VIX in the coming days…

Here’s a quick breakdown of what it is and why it matters:

The Volatility Index ("VIX") was created by the Chicago Board Options Exchange as a real-time market index representing the market's expectation of 30-day forward-looking volatility.

It is often referred to as the "Fear Index" by investors.

Let's take a look at how it works…

Volatility measures the magnitude of price movements—up and down—over a set period of time.

Historical volatility is based on actual historical price movements.

Forward-looking volatility—“implied volatility"—is inferred based on option prices.

The VIX infers its value by tracking the pricing of S&P 500 index options.

But what do S&P 500 options prices have to do with investor fear?

When investors expect stock prices to make a significant move—up or down—they typically purchase more options to protect themselves against those movements.

Think about it as buying insurance to protect your home if you’re expecting a hurricane to hit soon.

So in an environment where investors expect a big near-term price drop, it is reasonable to expect a surge in demand for put options.

There is more uncertainty in the market, so investors seek protection via these options.

Demand for them rises.

If demand rises quickly, supply will not have a chance to catch up.

Econ 101 tells us that the price of the options must rise.

Since we know the VIX tracks the pricing of S&P 500 index options, we can see the relationship forming.

S&P 500 put option prices spike = VIX spike.

To use a real example, the VIX spiked to a peak of >80 in mid-March 2020 as fears of COVID-19 damage peaked.

Typically, VIX values <20 correspond to stable, low-stress periods in the markets.

Spikes above that indicate volatile, high-stress periods in the markets.

Since the VIX is an index, you cannot trade it directly.

But this is finance, so interested investors can speculate on movements in the VIX in a number of other ways:

- VIX futures contracts
- VIX options
- VIX ETFs ($VIXY)

That’s a (very) simple primer on VIX. I hope it makes you feel more well informed in the days and weeks to come.

Follow me @SahilBloom for more plain English, explain it to me like I’m 5 explanations on business and finance.

A lot of questions about the $VXX and what happened that drove the decoupling with the $VIX there today…

Here’s my best guess:

VXX is an exchange traded note, meaning it’s just an obligation of Barclay’s to pay 1x the daily return of short-term VIX futures.

They hedge the exposure by buying short-term VIX futures.

If VIX liquidity was tough, hedging would be difficult, so cut off new sales to de-risk.

But by doing that, there’s an inherent decoupling from the underlying index, as the VXX can be bought without a corresponding trade in the underlying VIX futures.

This can lead to a ferocious short squeeze that we saw and a dramatic decoupling from the underlying index.