Predicting Volatility with the VIX (Part 1)

09/29/2009 12:01 am EST

Focus: STRATEGIES

John Jagerson

Co-Founder and Contributor, LearningMarkets.com

The VIX is an index, a technical indicator, and a security you can trade all in one. It is arguably the best gauge of risk and sentiment available to the investing public and can be used effectively by any trader within any market. This series of articles will define what the VIX is and how it works. You will learn how to use it within your daily analysis and how to invest or trade the VIX as a potential source of profits.

The VIX is often nicknamed the "fear index," which is actually somewhat misleading since it doesn't directly measure fear of any kind. The VIX is actually a measure of trader's expectations about volatility in the S&P 500. The VIX is charted like an index and the higher it goes, the higher traders’ expectations are for short-term market volatility.

Learn more about what happens when the VIX disagrees with market direction.

The VIX rises with higher market volatility because it measures the prices of the out-of-the-money S&P 500 index options. If option sellers think volatility is going to increase (in the near term), they will require larger premiums from option buyers. This increase in option prices is used in the calculation for the VIX index. Conversely, if traders think volatility is going to drop, option sellers will have to reduce premiums to attract buyers. Falling option prices will be reflected in a falling VIX index.

The VIX will track these changes in investor sentiment and option premiums in real time each trading day. The VIX is reading 30, or 30%, as this article is being written, which is an annualized number of how much traders think the S&P 500 will move over the next 30 days. That means that traders think the S&P 500 is likely to move about 2.5% (30% / 12 months = 2.5%) over the next month.

Trader expectations as shown on the VIX are directionless. In the example above, we can understand that traders are expecting a 2.5% move one direction or the other, but not specifically up or down. However, because unexpected market volatility is biased to the downside, a rising VIX is usually associated with bearish expectations. Remember that the market doesn't crash up; it only crashes down.

That means that if traders are expecting a lot of volatility, it is generally a bearish sign. That is one of the reasons the VIX is often called a measure of fear. If investors are concerned that volatility is increasing, the VIX will rise. Conversely, if investors are expecting low volatility, the VIX will drop, and that is considered bullish. This rule is generally true, but you will see exceptions on a day-to-day basis. We will talk about that more in the next article in this series.

The implications here are obvious. If the VIX is falling, investors are trading bullish strategies and taking on more risk. If the VIX is rising, traders may be shorting the market and trying to limit risk within their portfolio. Because the VIX is typically range bound, traders are particularly interested in periods when the index is hitting support or resistance levels.

How bearish or bullish traders feel based on the VIX index is important because it indicates what is going on with attitudes towards risk. Recently, increases in investor fear have been associated with falling stocks, rising bonds, and a stronger dollar. The same is true in reverse, as the VIX has been retreating from multi-year highs in early 2009.

The VIX can be found through many free charting applications, most commonly under the symbols VIX, $VIX, or ^VIX. The growth in interest in the VIX has spawned other volatility indexes that track oil, gold, the EUR/USD exchange rate, and other stock indexes. These are also very helpful and you will learn more about them in the next article in this series.

Now, watch the video for more details:

By John Jagerson of LearningMarkets.com.

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