How Options Gauge Wall Street Fear

Wall Street can be a risky place, but how is risk gauged? Meet the VIX, VXN and VXO.

The VIX, VXN and VXO are volatility indexes often used as indicators of how investors feel about the market’s future volatility. All are indicators of perceived market risk over the next 30 days. According to Investopedia, the VIX may sometimes be referred to as the “investor fear gauge” or “Wall Street’s fear gauge.”

Photo by martinhoward, courtesy of flickr

Each volatility index is reported as an annualized standard deviation (of the returns of the underlying index). The value of the volatility index is based on options traded on the corresponding index.

Here are the three most popular volatility indexes:

VIX – The VIX tracks options traded on the S&P 500.

VXO - The VXO tracks options traded on the S&P 100.

VXN - The VXN tracks options traded on the Nasdaq 100.

The indexes are trading currently at 29.78, 29.41, and 30. So as of today, the Nasdaq 100 is barely the riskiest of the three.

Generally speaking, a volatility index of greater than 30 is a sign of risky times ahead. According to Bloomberg, the VIX average value (since inception in 1990) is 20.18, but there have been some extreme levels in times of uncertainty.

Just to put things in perspective, the VIX rose to 31.47 on the day that Lehman Brothers filed for bankruptcy. Last October, the index reached a record 89.53. Less than 10 days ago, the VIX finally returned to pre-Lehman bankruptcy levels.

Gauging risk is important because risk is a determinant of an option’s value. All else held constant, riskier options will cost more so keep an eye on the VIX!