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.

Gauging fear

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 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.

Contrarian investors — 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. 

That said, research shows stock markets, on average, tend to perform better following low VIX readings compared to high ones.²

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 12 months, using an analysis of the difference between current SPX put and calls option prices.¹

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

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 instruments that respond to its fluctuations, such as the CBOE's VIX futures and options. These contracts have an expiration date, unlike stocks on the S&P 500. 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. "Whether an investor's outlook on the market is bullish, bearish or somewhere in between — VIX options and futures can provide the ability to diversify a portfolio or hedge, mitigate or capitalize on broad market volatility."³

There are also about two-dozen 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. ETNs, like bonds, can be bought and sold or held to maturity.⁴

Volatility ETPs tend to move in the opposite direction of the S&P 500. In other words, when the S&P 500 falls, volatility ETPs will rise.⁵ For example, the VIX averaged 14.06 on July 1, 2019 when the S&P 500 hit a record high.

Historical performance for the CBOE Volatility Index (VIX)
Source: www.cboe.com

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.

Over the last few years, for instance, the VIX has had long stretches at or below its long-term historical average despite various 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.

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 article is provided as a general source of information and should not be considered personal investment advice or a solicitation to buy or sell any mutual funds and other securities.