A Google search on VIX yields some unexpected pages: the name of a Czech rock band, a swim wear catalog and the Vienna Internet Exchange. Interesting stuff, but not quite what we had in mind, the CBOE's VIX, an increasingly popular market-timing indicator, one that is grabbing center stage. Let's take a look at how VIX is constructed and how investors can use it to evaluate U.S. equity markets.

What Is the VIX?
VIX is the symbol for the Chicago Board Options Exchange's volatility index. It is a measure of the level of implied volatility - not historical or statistical volatility - of a wide range of options based on the S&P 500. This indicator is known as the "investor fear gauge" because it reflects investor's best prediction of near-term market volatility, or risk. In general, VIX starts to rise during times of financial stress and lessens as investors become complacent. It is the market's best prediction of near-term market volatility.

Implied volatility is the expected volatility of the underlying, in this case a wide range of options on the S&P 500 Index. It represents the level of price volatility implied by the option markets, not the actual or historical volatility of the index itself. If implied volatility is high, the premium on options will be high and vice versa. Generally speaking, rising option premiums (if we assume all other variables remain constant) reflect rising expectation of future volatility of the underlying stock index, which represents higher implied volatility levels.

VIX and Stock-Market Behavior
While there are other factors at work, in most cases, a high VIX reflects increased investor fear and a low VIX suggests complacency. Historically, this pattern in the relationship between the VIX and the behavior of the stock market has repeated itself in bull and bear cycles, patterns we will look at in more detail below. During periods of market turmoil, the VIX spikes higher, largely reflecting the panic demand for OEX puts as a hedge against further declines in stock portfolios. During bullish periods, there is less fear and therefore less need for portfolio managers to purchase puts.

By measuring investor fear levels tick by tick and day by day, the VIX, like many emotional gauges (e.g. put/call ratio and sentiment surveys), can be used as a contrary opinion tool in attempting to pinpoint market tops and bottoms on a medium-term basis. There are two ways to use the VIX in this manner. The first is to look at the actual level of the VIX to determine its stock-market implications. Another approach involves looking at ratio comparing the current level to the long-term moving average of the VIX. This second method, known as detrending, helps to remove long-term trends in the VIX, providing a more stable reading in the form of an oscillator.

When the Measures of Fear Show No Investor Fear
Let's take a closer look at some numbers for the VIX to see what the option markets tell us about the stock market and mood of the investing crowd.

Figure 1 - Daily VIX, oscillator and S&P 500. Source: MetaStock Professional.

Figure 1 shows the VIX in the summer of 2003 flirting with extreme lows, dipping to near or below 20. A look at figure 2 should be an eye opener as it shows that each time the VIX has declined below 20, a major sell-off has taken place shortly after. Whenever the VIX dips below 20, the stock market marks a medium-term top. As the VIX is breaking below 20 in figure 1, it indicates that the investment crowd is extremely complacent about the current outlook, having little reason to worry.

Figure 2 - Daily VXN, oscillator and S&P 500. Source: MetaStock Professional.

It's interesting to note that the VXN, which is the symbol for the implied volatility index of the Nasdaq 100 index, is even more bearish at the end of the summer of 2003. In Figure 2, the VXN (which is calculated the same was as the VIX) dropped to levels not seen since the complacent summer of 1998, when the VXN was below 29.5. A major sell-off had ensued almost immediately.

Moreover, detrended oscillator levels below -5.00 (same for the VIX) generally precede a sell-off, although sometimes this indication of the sell-off may be early, which might've been the case for the Sept 2003 readings. In fact, the stock indexes appeared to be levitating given the low readings on the VIX and VXN at that time (as seen in the bear-like S&P pattern on the charts in Figures 1 and 2). At that time it was certainly reasonable to expect stock averages to move higher still, but also for them to be accompanied only by even lower VXN and VIX levels. History shows, however, that complacent investors may be punished with falling prices unless they heed the warnings of this quite reliable indicator.

Remember, there is risk of loss trading options and futures, so trade with risk capital only. Past performance does not guarantee future results.

by John Summa (Contact Author | Biography)

John Summa, Ph.D., is the founder and president of OptionsNerd.com LLC, and TradingAgainstTheCrowd.com. He co-authored "Options on Futures: New Trading Strategies and Options on Futures Workbook" (2001). He is also the author of "Trading Against The Crowd: Profiting From Fear and Greed in Stock, Futures and Options Markets" (2004), which presents contrarian sentiment trading indicators and trading systems for stocks, futures and options. Summa is also co-authoring a book on hedging employee stock options, which will be published in late 2009.

Founded in 1998, OptionsNerd.com provides professional training and educational support to stock, options and futures traders. Summa is an economist, author, options trader and former professional skier, and he presents small-group, online and in-person training seminars. Visit OptionsNerd.com or TradingAgainstTheCrowd.com for more information.