Volatility matters: Why you should watch the VIX

Investors always want to know which way markets are headed. While there is no perfect way to predict it, one popular gauge is the Chicago Board Options Exchange (Cboe) Volatility Index, also known as the VIX, which tracks implied market volatility in real time.

What is volatility?

Whether you’re looking at stocks, bonds or another financial asset, volatility is how fast its price changes, and how large the price swing is. Volatility can be seen as a way to assess market sentiment.

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What is the VIX?

The VIX represents the market’s expectations for volatility for the S&P 500 Index (SPX) over the next 30 days. The larger the price swings, the higher the level of volatility.

The VIX is an important index because it provides a measure of market risk and investor sentiment, which can be helpful when making investment decisions.

How is the VIX calculated?

The VIX uses a mathematical formula that measures how much the market thinks the S&P 500 Index option (SPX) will fluctuate over the next 30 days, using an analysis of the difference between current SPX put and calls option prices.

Options prices are based on a number of factors, including investors' expectations of market volatility between the current date and the expiration date.

What do VIX readings mean?

In general, a VIX reading below 20 suggests a perceived low-risk environment, while a reading above 20 is indicative of a period of higher volatility.

The VIX is commonly used to measure investor confidence in the market. It is sometimes referred to as a "fear index," since it spikes during market turmoil or periods of extreme uncertainty. For instance, the VIX spiked in the fall of 2008, around the height of the global financial crisis, climbing above 80 towards the end of that year. It stayed below 13.5 from mid-September 2006 until the end of February 2007, when markets were performing well.

Similarly, in mid-March 2020, just as most countries were going into lockdown due to the COVID-19 pandemic, the VIX spiked again, reaching 82. Throughout most of 2020, continued uncertainty kept the VIX elevated, but it finally declined to under 20 in 2021.

Contrarian investors — those who look for market opportunities by going against conventional thinking—consider a low reading on the VIX to be a bearish signal, indicating market complacency that may spell bad news ahead, while a high VIX reading is believed by some to be a bullish signal. 

However, historically speaking, stock markets on average have tended to perform better following low VIX readings compared to high ones.

How the VIX is traded?

The VIX is, by nature, volatile; therefore, trading it is speculative. As such, self-directed investors should do their own research and ensure they're comfortable with the risks of losing some or all of their initial investment.

For those who are comfortable with the risks associated with these kinds of investments, while you can't buy the VIX in the same way you can buy a stock or bond, you can invest in securities that respond to its fluctuations, such as VIX futures and options. These contracts have an expiration date, unlike stocks on the S&P 500 Index. With stocks, you have ownership in a company, while options are contracts that give you the right to buy or sell a stock at a certain price on or before a certain date.

According to the Cboe, VIX options and futures enable investors to trade volatility independent of the direction or the level of stock prices. There are also volatility exchange-traded products (ETPs) for the VIX, including both exchange-traded funds (ETFs) and exchange-traded notes (ETNs). ETFs are investments that hold assets, such as stocks, bonds or commodities, while ETNs are unsecured debt notes.

Don’t let the VIX vex you

While the VIX is widely used as a measure of how the market is feeling, it doesn't necessarily represent market risk—especially long-term risk. The VIX has had long stretches at or below its long-term historical average despite a variety of geopolitical concerns. Still, interested investors continue to follow the VIX for evidence of what might happen next on the markets, including whether it's the quiet before another storm.

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The information contained in this article was obtained from sources believed to be reliable; however, we cannot guarantee that it is accurate or complete. This material is for informational and educational purposes and it is not intended to provide specific advice including, without limitation, investment, financial, tax or similar matters.