Traders have long been able to find ways to create mathematical formulas to track certain types of market movement so that they can then place bets on them. Between the hundreds of different indices and ETFs out there, if you have a prediction about just about anything that might happen throughout the global economy, there’s a way to profit (or NOT profit) from your inkling.

And one of the most popular things they’ve ever created was the formula that’s now used for the Chicago Board Options Exchange Market Volatility Index (VIX). It uses options trades as a barometer for how volatile traders expect the market to be over the next month. Since it was introduced in January of 1993, the index has captured the interest of traders and investors alike, with the S&P 500 VIX Short-Term Futures ETN (VXX) coming in as the third most popular ETF, with average volume of almost 45 million shares.

But what does the VIX really mean? It’s known as the “fear index,” and generally believed to reflect panic in the markets. But is that what it’s really supposed to mean?

Calculating Volatility

Given its popularity, it should be important to note what, exactly, the VIX is supposed to track. It’s not a measure of present volatility. Nor is it technically a prediction of future volatility, though one could choose to read it as such. Rather, the VIX is a measure of current market sentiment regarding future volatility. Basically, what are today’s traders doing while they try to predict what’s going to happen over the next 30 days? When traders appear to be anticipating big moves in the market in the next 30-days, it should mean the VIX goes up. If they appear to be betting on smaller market moves, it goes down.

The benchmark that’s used to measure that current market sentiment is options trading. The method was developed by Prof. Menachem Brenner and Prof. Dan Galai in 1986 and then published in the July/August 1989 issue of Financial Analysts Journal. Without going to deep into options, they’re essentially contracts to either buy or sell stock at a certain price at a future date. Basically a way to bet on whether or not a stock will go up or down without actually buying the stock. The VIX tracks what options are being bought and sold, and how big the strike price on those options are. A larger strike price implies that the person buying the option forsees a bigger move in that stock’s price. So, if options are being written with larger strike prices, it probably means the market is anticipating bigger swings over the length of those options.

The Fear Index?

So, it should be noted that the index is not intended to be predictive. It’s measuring the current market sentiment about the next 30 days. Traders seem to believe that the S&P is going to make a big move, but that doesn’t mean that they’re right. In fact the correlation

It should also be noted that the index doesn’t indicate whether the anticipated movement is up or down. A large volume of traders buying call options with high strike prices would indicate they’re predicting a bull market, and it would also push up the VIX.

And this is important, because the perception of the VIX as the “fear index” appears to be inaccurate. It's not an indication that a major sell-off is forthcoming. In fact, it could mean just the opposite. The only thing a high VIX should mean is that people buying options are anticipating a lot of movement in the market over the next month. It doesn't really mean anything else.

Or does it?

A Self-fulfilling Prophecy

Perception can mean everything. And the idea that the VIX is the “fear index” is a powerful one. A sharp rise in the VIX is enough to make some traders sell off equities and shift into a risk-off environment. And, of course, if an increasing VIX results in people selling equities, it means it can result in the equities market falling anyway.

So whether or not traders really understand what the VIX means, the fact that they believe it’s the “fear index” makes it the “fear index” on some level. Which can mean that, despite what the VIX actually measures and should represent, the effect it has on the market ends up being that of a "fear index."

A Volatile Way to Trade

Ironically, what makes the VIX such a popular trading vehicle through its ETF is that it's so volatile. So the index tracking volatility is volatile. Go figure. The volume of shares trading hands on the major VIX ETFs proves that traders are interested in continuing to follow the "fear index."

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer.