By Daniel Archibald | CFA
When referencing the riskiness of investments, it is common for practitioners to refer to volatility. Otherwise known as the standard deviation of return, this important statistic is used to help measure an otherwise abstract concept - investment risk.
Measuring volatility can be a difficult task. Generally-speaking, volatility (or standard deviations) is derived statistically by looking at the dispersion of asset returns. Assets that have a wider range of returns are treated as being more risky, whereas those with a tight range of returns are seen to be less risky.
However, return data, at times, can be less than reliable. This is especially so for assets that have infrequent trades, and thus, less frequent movements in price. For example, the CBA share price will move around on a micro-second level, as traders buy and sell large volumes of shares. Conversely, the price of a commercial property in Dubbo might only be struck once a decade. Just because the price is stable for this commercial property, does it make it less risky than CBA shares?
In order to cut through some of the issues associated with measuring volatility based on asset price movements, a more contemporary method has been formulated. This volatility measure, rather, is based upon the implied volatility inherent within option prices, and is commonly known as a VIX (derived from the term "volatility index"). The mechanics of extrapolating the volatility of an underlying asset from its traded options is well beyond the scope of this article. The first VIX was created in 1993 by the Chicago Board Options Exchange and was a weighted measure of eight S&P100 index call and put option implied volatilities. The "VIX" is generally accepted as being the volatility index over the US share S&P500 index.
The VIX - From 1990 (back-dated) to 2015
Source: Yahoo Finance 2016
In general, the VIX runs counter to market returns. When the VIX is high, it is common for markets to be plummeting and when it is low it is common for markets to be trending slowly upwards. In October 2008, a month after Lehman Brothers filed for bankruptcy, the VIX hit an all-time, intra-day high of 89.53 (as shown by the spike in the above graph - weekly close of about 60). In normal market conditions, the VIX tends to sit around 15-20.
It is now possible to trade the VIX (just as you would trade shares), via VIX futures and options, and there are similar VIX products over different markets including the Nasdaq (VXN) and the S&P/ASX 200 (A-VIX).