How is the Volatility Index calculated?
Answer:
I'm sure it has gotten a lot more complex over the years but I can give you an idea.
For a single option, in the Black Scholes option equation, one of the variables is the volatility of the stock. The equation is used to calculate the value of the option. Well, if you have the price (=perceived value) of the option (as dictated by market forces), you can use that price in the equation to "back into" the volatility. You can use something like the "solver" function in excel to find a volatility that yields the price set by the market. Thus you have a volatility that the market "feels" verses the volatility usually computed by the standard deviation of the stock price over some period.
For the VIX, they don't use options on a stock, they use options on the S&P 500 index. That way they are getting some average volatility.
Of course this is a very simplified explanation. There are other factors like which option(s) to use, how to handle cases where different options on the index yield different volatilities etc.
You might find more at:
http://www.cboe.com/micro/vix/introducti.
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