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What Is the Market Volatility Index, and How Does It Impact Your Investments?

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The Market Volatility Index (ticker symbol: VIX) is a tool that the Chicago Board Options Exchange (CBOE) created in order to give traders a reliable estimation of upcoming volatility in the overall stock market. To put things simply, the VIX is kind of like a forecast for the market, predicting either clear sailing or choppy waters. But it does get a bit more complicated than that, and it's important to understand the role this tool can play in the ways you manage your investments. Let's delve into what the VIX does, how it works and how you can use it to make better-informed trading decisions.

Why Is Market Volatility Important?

The VIX is also sometimes jokingly referred to as Wall Street's "fear index" or "fear gauge," an assessment that does have a bit of truth to it. The idea behind it is to measure how much prices on the overall stock market are likely going to move (and how quickly) over certain lengths of time. Why is this important?

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When volatility — the rises and drops in value an investment experiences over time — is high, there's a great deal of buying and selling going on, as well as a greater deal of uncertainty. Prices can move up or down at a much faster rate with shares of a volatile stock, so for investors, buying and selling at the right time becomes even more critical. When volatility is low, there's less trading happening, and prices tend to move along with fewer swings in either direction.

In general, the VIX provides traders with an idea of what kind of action to expect from the stock market in the near future. It can help identify trends, determine what type of investment strategies are likely to yield the best results and provide a sense of how active large, institutional investors are likely to be. And keeping up with the movements of institutional investors — such as hedge funds, mutual funds, investment banks, pension funds and insurance companies — is incredibly important for individual investors. This is true simply because the majority of stocks on the market are owned and traded by large institutions. These large entities are the types of traders that have the ability, because of their high-volume stock ownership, to affect the price of any given stock for better or worse. It's not uncommon to find success in riding their coattails when it comes to making investment decisions.

How Does the VIX Measure Market Volatility?

How exactly does the VIX go about predicting upcoming volatility in the market? It can get a bit complicated, so don't feel like you have to have a thorough academic understanding of how the VIX works in order to use it.

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That said, know that its basis lies in tracking the prices of a range of options on the S&P 500 (SPX), which is an index of the largest 500 publicly traded companies on the U.S. stock market. The health of the stocks in this particular index is often used to gauge the overall health of the stock market at large. As far as the way VIX uses the S&P 500 to make volatility predictions, according to CBOE, "The VIX Index is a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500 Index (SPX) call and put options."

While this can be a complicated concept, it boils down to the idea that, by calculating the midpoints of option bid/ask prices in real-time, the VIX can essentially predict the level of uncertainty in the market. By examining what the results of its calculations have indicated about market behavior in the past and present, the VIX can predict what the market is likely to do in the next 30 days with impressive clarity.

Is it always 100% accurate? Definitely not. And the idea that it's meant to be is a common misconception. According to a white paper published on the CBOE website, the VIX Index is often overestimated by around 4 or 5 percentage points. This is simply a form of insurance that provides a bit of leeway in case of surprises.

To use an analogy, it's sort of similar to when you order a package and the company tells you to expect its delivery in 7–10 business days. If it's delivered sooner, that's great. But if it takes the full 10 days, you still knew that was a possibility, even if it made you a bit impatient or disappointed. In the same way, the VIX Index is meant to give traders an idea of what upcoming market conditions will be like within a reasonable range.

How Can Investors Use the VIX?

In considering how the VIX can help you as an average trader, keep in mind that its predictions can give you an idea of how volatile the market is probably going to be but not necessarily which direction it's going to go in.

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In general, the VIX Index is often an inverse image of the market itself. When the value of the S&P 500 is up, the VIX tends to fall as traders settle in and hold their shares because the stocks themselves are worth more. On the other hand, when the VIX is up, that means that there's more trading going on of the stocks of the S&P 500, which indicates that there's ample buying and selling taking place.

As you can see in the graph above, the VIX soared to an incredible high during the recession of 2008, when the market itself was crumbling. That said, there are times when the VIX Index can actually fall along with the market itself, especially after a period of strong volatility.

So if the VIX Index is up (or down), is that a good or bad sign? This largely depends on your trading strategy. One old stock market adage advises "When the VIX is high, it's time to buy. When the VIX is low, look out below!" And indeed, many traders do buy when volatility is high and sell when it's low. On the other hand, some traders do the exact opposite, preferring to buy when volatility is low and sell when it goes back up.

The reality is that there are several different ways to approach trading based on volatility. The important thing to know is that if the VIX is reading low, then the market may not experience a great deal of activity in the coming days, as traders are becoming more complacent. If it's reading high, then there's more supply and demand variability as stocks are being bought and sold at more frequent rates and are fluctuating more radically in price.