More and more investors are using options prices offered by the Chicago Board Options Exchange's Volatility Index (VIX), to help determine market direction.

The VIX is one of the investment industry's most widely accepted methods to gauge stock market volatility, and for good reason. Here we'll take a look at why it works and how you can make it work for you in your trading endeavors. (For background reading, see Volatility's Impact On Market Returns.)

VIX 101
The first version of this index was developed by the Chicago Board Options Exchange in 1993 and was calculated by taking the weighted average of implied volatility for the Standard and Poor's 100 Index (OEX) calls and puts. However, in September 2003, this was revised to provide a more accurate depiction of broad market volatility. In essence, VIX is a gauge of investors' confidence or non-confidence in market conditions.

It is important to understand that the VIX does not measure the volatility of a single issue or option instrument, but uses a wide range of strike prices of various calls and puts that are all based on the S&P 500. What is formed is a more accurate measure of the market's expectation of near-term volatility. (For further reading, see Getting A VIX On Market Direction.)

Determining Market Direction
Incorporating a wide range of S&P 500 Index options truly makes this index a cross-section of investor sentiment. The VIX has an inverse relationship to the market. A low VIX - within a range of 20 to 25 - indicates that traders have become somewhat uninterested in the market and generally leads to a period of heightened volatility. The value of VIX increases as the market becomes fearful and decreases when the market feels confident about its future direction. A rising stock market is seen as less risky and a declining stock market more risky. The higher the perceived risk in stocks, the higher the implied volatility and the more expensive the associated options, especially puts, become. Hence, implied volatility is not about the size of the price swings, but rather the implied risk associated with the stock market. When the market declines, the demand for puts usually increases. Increased demand means higher put prices and higher implied volatilities. (For more insight, see Implied Volatility: Buy Low And Sell High.)

For contrarians, comparing VIX action with that of the market can yield good clues on the future direction or duration of a move. The more VIX increases in value, the more panic there is in the market. The more VIX decreases in value, the more complacency there is in the market. As a measure of complacency and panic, VIX is often used as a contrarian indicator. Prolonged and/or extremely low VIX readings indicate a high degree of complacency and are generally regarded as bearish. Some contrarians view readings below 20 as excessively bearish. Conversely, prolonged and/or extremely high VIX readings indicate a high degree or anxiety or even panic among options traders and are regarded at bullish. High VIX readings usually occur after an extended or sharp decline and sentiment is still quite bearish. Some contrarians view readings above 30 as bullish. (For further reading, check out Volatility - The Birth Of A New Asset Class.)

Conflicting signals between VIX and the market can yield sentiment clues for the short term. Contrarians see overly complacent readings as bearish. On the other hand, panic is regarded as bullish. If the market declines sharply and VIX remains unchanged or decreases in value (towards complacency), it could indicate that the decline has farther to go. Contrarians might take the view that there is still not enough bearishness or panic in the market to warrant a bottom. If the market advances sharply and VIX increases in value (towards panic), it could indicate that the advance has farther to go. Contrarians might take the view that there is not enough bullishness or complacency to warrant a top.

Figure 1
Source: MetaStock

Figure 1 shows the VIX indicator from April 2007 to February 2009. As you can see, the VIX spiked in September 2008. This unprecedented rise in the VIX coincided with extreme panic and one of the sharpest drops in the history of the financial markets. The VIX values near the dotted trendline portray a much different picture; they could be used to predict bullish sentiment and a much less volatile period of investing. Given the unfolding of the credit crisis in late 2008 , it is not surprising to see that the VIX was suggesting that panic was dominating the market. (For related reading, see Top 5 Signs Of A Credit Crisis.)

This is an indicator that is rarely out of step when it is viewed from market directions on a broad scale and will more than likely help investors see the bottom forming and the next strong bull market develop.

VIX is one of the most widely accepted ways of gauging stock market volatility. It is often referred to as the "investor fear gauge", and has lived up to this name in its ability to measure times of uncertainty and times of complacency in the market. Even in the most volatile markets, VIX can help investors get a sense of when the market has finally hit bottom - a welcome sign of better things to come.

Related Articles
  1. Options & Futures

    Volatility - The Birth Of A New Asset Class

    Learn more about the trading possibilities with the VIX.
  2. Options & Futures

    Introducing The VIX Options

    Discover a new financial instrument that provides great opportunities for both hedging and speculation.
  3. Options & Futures

    Volatility's Impact On Market Returns

    Find out how to adjust your portfolio when the market fluctuates to increase your potential return.
  4. Options & Futures

    Determining Market Direction With VIX

    The CBOE's volatility index is a helpful market indicator. Learn how it can gauge the mood of the stock market.
  5. Options & Futures

    Option Price-Volatility Relationship: Avoiding Negative Surprises

    Learn about the price-volatility dynamic and its dual effect on option positions.
  6. Options & Futures

    Using The VIX For Shorting Opportunities

    Find out how to use this tool to identify opportunities.
  7. Chart Advisor

    Breakout Opportunity Stocks: CPA, GNRC, WWE

    After a period of contracting volatility, watch for breakouts and bigger moves to come in these stocks.
  8. Options & Futures

    What Does Quadruple Witching Mean?

    In a financial context, quadruple witching refers to the day on which contracts for stock index futures, index options, and single stock futures expire.
  9. Options & Futures

    4 Equity Derivatives And How They Work

    Equity derivatives offer retail investors opportunities to benefit from an underlying security without owning the security itself.
  10. Options & Futures

    Five Advantages of Futures Over Options

    Futures have a number of advantages over options such as fixed upfront trading costs, lack of time decay and liquidity.
  1. What is Fibonacci retracement, and where do the ratios that are used come from?

    Fibonacci retracement is a very popular tool among technical traders and is based on the key numbers identified by mathematician ... Read Full Answer >>
  2. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  3. What is after-hours trading? Am I able to trade at this time?

    After-hours trading (AHT) refers to the buying and selling of securities on major exchanges outside of specified regular ... Read Full Answer >>
  4. How do hedge funds use equity options?

    With the growth in the size and number of hedge funds over the past decade, the interest in how these funds go about generating ... Read Full Answer >>
  5. Can mutual funds invest in options and futures? (RYMBX, GATEX)

    Mutual funds invest in not only stocks and fixed-income securities but also options and futures. There exists a separate ... Read Full Answer >>
  6. What are some of the most common technical indicators that back up Doji patterns?

    The doji candlestick is important enough that Steve Nison devotes an entire chapter to it in his definitive work on candlestick ... Read Full Answer >>
Hot Definitions
  1. Presidential Election Cycle (Theory)

    A theory developed by Yale Hirsch that states that U.S. stock markets are weakest in the year following the election of a ...
  2. Super Bowl Indicator

    An indicator based on the belief that a Super Bowl win for a team from the old AFL (AFC division) foretells a decline in ...
  3. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  4. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  5. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  6. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
Trading Center