By John Jagerson, Learning Markets Analyst¹

What is the VIX?

Perhaps you've heard of the VIX? It's often mentioned on investing programs or highlighted in articles written about the markets. Commentators will refer to the VIX when the stock market enters a period of uncertainty or when we see large price swings. The VIX is the CBOE market volatility index and is essentially a measurement of expected market volatility over the next 30 days. Volatility tends to increase when investors grow more concerned about the markets and by extension more uncertain about what the future may hold. This is why the VIX is often referred to as the "fear index." This article will help you understand what the VIX is and the various ways investors use the VIX to manage their trades.

The VIX is basically a calculation of the expected movement (in percentage points) of the S&P 500 index over the next 30 days. The VIX is calculated by looking at the variances in option strike prices from the front-(current) and second-(next) months of expiration (using S&P 500 index options). The VIX calculation takes this variance, annualizes it, and then quotes it as a percentage. The general theory behind the formula is that as option prices fluctuate the underlying contracts are pricing in traders' forecasts for price moves going forward. As such, it gives us a view of expected variance in the S&P 500 over the next 30 days. The greater this variance, the greater the "fear" expressed by traders based on these pricing differences.

The VIX works like this because of the reasons why investors buy or sell options on the S&P 500 index. Most individual investors tend to trade options on individual stocks or ETFs because they are speculators--buying options because they think a stock is either going to go up or down in the short term. S&P 500 options, however, are a popular tool used by institutional money managers for hedging their portfolios, which is a method of risk control rather than speculation.

The VIX index fluctuates according to option supply and demand as well as expected supply and demand. When SPX options are being bought (more demand), the index is driven higher. When SPX options are being sold (more supply), the index is driven lower. Because SPX options are a common tool for hedging, where institutions are buying options to protect their portfolios against losses from a market decline, we can deduce that, as the index goes up, the cause is an underlying "fear" that the market might be in a position to fall.

Interpreting the Chart

When analyzing the VIX chart there are two important considerations that should be made:

1) How high or low the index is relative to where it has been in the past

2) How wide is the range between support and resistance levels?

As a rule of thumb, when the VIX is above 25 you can expect market conditions to be more volatile and potentially more open for a correction or downturn. When the VIX is below 20, conditions are more stable and there is a greater potential to develop an upward trend. The range between support and resistance levels on the VIX will also be much larger at higher index values. When the VIX is above 25 the range is approximately 15 points, while when below 20 the range tends to be closer to 5 to 7 points. It is important to note that the smaller the VIX range, the more comfortable investors tend to be, which in turn makes them more likely to be stock buyers.

Apply the VIX to your trading

Traders will consider current market conditions -- what the VIX is telling them -- and make trading decisions accordingly. For example, a trader may adjust the number of positions they have open at the time, how long they expect to hold those positions, and where they might set stop-loss orders to protect open positions.

In addition to giving insight as to current market conditions, the VIX can also help to signal when conditions may be changing. This can help to identify when a bull market might begin to reverse, or "correct," or even worse, turn into a Bear market. In the image below we're showing a chart of the VIX and a chart of the SPX. The boxed in areas in the chart indicate periods where the VIX spiked up through its current range. You can see how these spikes indicated that a considerable drop was possible on the S&P 500 index. These "spikes" in the VIX can help traders make decisions such as when to tighten up a stop-loss or when to take profits on open trades.

To view a chart of the VIX on the Scottrade website all you need to do is enter the symbol "$VIX" into the detailed quotes box on Scottrade.com.

¹This content was created and is being presented by an independent party not employed by or affiliated with Scottrade or its affiliates. Scottrade, Inc. and its affiliates have not created and are not responsible for such materials. The content of such materials has not been adopted, endorsed or approved by Scottrade or its affiliates and does not reflect the opinion, belief or recommendation of Scottrade.