Imagine trading and your screen goes blank. Even with thousands of traders, there are no bids, at any price, and there’s no more money.
That’s what happened on Black Monday in October 1987, when the Dow dropped more than 500 points in a day. Though trading was still being done face to face then, eyes were down and hands were in pockets.
Market crashes are scary, even with products to hedge market exposure. But while futures allowed traders the ability to do so, there was no measure of volatility.
Enter the Chicago Board Options Exchange Volatility Index (VIX): The first index quantification of market volatility, and a valuable tool for understanding it.
After its introduction in 1993, VIX became the benchmark for U.S. stock market volatility.
“It’s the premier hedging product in the world,” says Tom Henrich, who worked as a floor trader for 24 years. “I don’t think that’s an exaggeration. People do other things to hedge, but the ability to concentrate your hedging into one instrument has [perhaps] never been in a product [other than] the VIX.”
How did a tool that did not exist 22 years ago become so crucial to market-makers, traders and analysts alike?
In the beginning
Volatility isn’t a new concept. “Before the implementation, before the VIX became available [as a calculated index], we would just tend to look at volume and extreme price movement as a proxy for what the VIX does now,” says Alan Bush, a senior research analyst with ADM Investor Services Inc.
While the impact of the VIX isn’t hard to see, its rise to fame is less clear. The need arose for an index to measure market expectation of near-term volatility, and the CBOE decided to meet it by developing a stock market volatility index based on index option prices. Later it would see the value in making this index tradable through both options and futures, pushing the CBOE to launch CBOE Futures Exchange (CFE).
“The CBOE created the VIX in 1993. At that point, it was based on the OEX (S&P 100 Index),” says Jay Caauwe, director of business development for the CFE.
In the early 2000s, the VIX measure shifted from being based on options on the OEX to options on the SPX (S&P 500 index), taking into account significantly more values. According to Caauwe, that’s because the CBOE saw that the VIX was a “widely regarded barometer of market sentiment,” but envisioned a larger potential for the VIX and need for an investable product and decided to fill it.
“Times change, markets change and we felt that the VIX index would be a lot more representative of volatility in the marketplace,” Caauwe says. “The out-of-the-money calls and puts reflect the entire sector, so it’s a lot more representative of options being traded at the CBOE, and a lot more representative of volatility, capturing strength.”
After individuals saw the value in an index for volatility, the CBOE believed the next step would be a tradable product that market-makers could employ as part of an overall portfolio management strategy, Caauwe says.
It took off. “It was a good idea that became a great idea,” Henrich adds.
The calculation is technical — and challenging to the point where even experienced traders struggle to calculate and interact with it — but the most prevalent measure of implied volatility is now something that many options brokers cannot operate without.