If you’ve been paying any attention to the markets during these turbulent times, it’s likely you’ve encountered references to the VIX, otherwise known as the Volatility Index, or its rather ominous nickname, the ‘fear index’. Given the devastating impact of the COVID-19 pandemic on global markets, ‘fear’ certainly feels like an apt word to reach for when attempting any sort of market forecast right now. Which, as it happens, is exactly what the VIX is designed to do.

Devised by the Chicago Board Options Exchange (CBOE), the Volatility Index provides a measure of market risk and investor sentiment by projecting forward and forecasting expected future volatility. The VIX doesn’t provide a measure of the market’s past volatility, it predicts its future volatility. In this respect it is fundamentally different to historical volatility, which measures annualised standard deviation as a percentage of stock price.

As a measure of implied (or expected) volatility and a continuously updated barometer of investor sentiment, The VIX is a useful resource for investors and analysts seeking to assess risk and measure market stress.

How does the VIX work?

Before we look at how the VIX calculates volatility, we should first consider what we actually mean by volatility in relation to the stock market. Generally speaking, volatility refers to the magnitude and rate of price swings. In other words, it’s a measure of how fast prices are changing. Big swings in either direction are associated with a volatile market.

High volatility describes dramatic price fluctuations over short time periods and is often linked to unpredictability and therefore greater risk. A calm market tends to result in a predominance of call option buying, while a volatile market usually goes hand in hand with a rush to buy puts.

The VIX is based on options of the S&P 500 Index, which is widely regarded as a good indicator of the broader U.S. stock market. It uses standard and weekly SPX options to calculate expected volatility by averaging the weighted prices of out-of-the-money puts and calls. The maths behind this calculation is too complicated to cover in detail here but you can read about the VIX formula in CBOE’s whitepaper.

Reading the VIX is rather more straightforward: Numbers represent the expected percentage range of movement of the S&P 500 over the following year at a 68% confidence level (one standard deviation of the normal probability curve). So, if the VIX is at 30, that equates to an expectation (with 68% probability) of no more than 30% change over the next year, up or down.

This can be converted into a monthly figure by dividing the reading by the square root of 12 (3.46). So, extending the above example, a VIX reading of 30 would suggest a monthly range of 8.7% (30 divided by 3.46).

The VIX is expected to reflect investor fear (or complacency) as a measure of implied volatility. Consequently, it tends to negatively track the S&P 500 Index, rising when the S&P drops and falling when it’s on the up.

How can VIX be used by investors?

As an indicator of market sentiment, the VIX can help investors to anticipate trends and devise hedging strategies. It effectively acts as a measure of supply and demand, rising when the demand for puts increases – a trend that tends to reflect anxiety in the market.

Paradoxically, buying when the VIX is high and selling when it’s low is a well-established strategy. Indeed, most seasoned investors will be familiar with the mantra “when the VIX is high, it’s time to buy; when the VIX is low, it’s time to go.” The theory behind this strategy is that market anxiety will likely be at its highest when prices are at rock bottom, just ahead of a correction.

Following this logic, the VIX can be used as a contrarian indicator: High levels – indicating fear in the market – can be interpreted as a positive sign that the market is on the cusp of bouncing back. By the same token, low VIX readings indicate that the market is complacent and could be about to drop.

Needless to say, the VIX isn’t a failsafe way to predict market trends, but it certainly offers a worthwhile insight into market sentiment and can be a useful tool when used alongside other market indicators.

Can I trade the VIX?

Aside from using it as a tool to inform your investing strategy, you can also trade securities that track the value of the VIX. While trading on the VIX itself can’t be done directly, it is possible to invest in the VIX indirectly through futures, options or VIX ETFs (Exchange Traded Funds).

VIX ETFs invest in VIX futures contracts and offer a fairly popular way to speculate on or hedge against future market moves. The only problem is that VIX ETFs have a poor record of correlating to the VIX itself, and many commentators regard them as poor long-term investments. However, they can be useful as a means to hedge against short-term market volatility. Because the VIX is expected to spike when the market crashes, you can expect a VIX ETF to rise as the market falls, making it an effective way to protect your portfolio, in theory at least.

You could learn a lot about how to trade VIX by following real-time and relevant news, tweets, and analysis here.