Tracking Volatility: A Primer on the VIX

When there's turmoil in the stock market, coverage of the fallout often includes mentions of the CBOE Volatility Index, also known as the VIX Index.

The most recent stock slide in the wake of the United Kingdom’s historic vote to leave the European Union is no exception. The VIX Index on Friday, June 24, surged nearly 50 percent on Friday as stocks fell across the globe after the polls showed 52 percent of U.K. citizens had voted to “leave” the E.U.

The VIX Index, dubbed the market’s “fear gauge,” measures expectation of future market volatility by tracking how much traders are willing to pay for SPX options tied to the S&P 500 Index. During periods of uncertainty, the gauge often rises.

That's the simple explanation. Here are a few finer points about the VIX Index to keep in mind:

How It Trends: Fear and Trading

The VIX Index measures expected market volatility over a 30-day period and is based on the midpoint point of real-time SPX options bid/ask quotes.

Why options? Because when investors grow anxious about their holdings — as often happens during market declines — they often turn to options to hedge their investments. And SPX options, in particular, are a common way for some investors to seek broad-portfolio protection. When more investors are clamoring for SPX options, they tend to become more expensive, which, in turn, tends to drive the VIX Index higher.

Some experts compare the situation to homeowners paying more for home insurance when the threat of a natural disaster is imminent.

"The cost of homeowners insurance in south Florida during hurricane season is higher relative to when we don't see an imminent threat. The premiums are going to go up when people are most concerned," said Russell Rhoads, the director of education at the Chicago Board Options Exchange Options Institute. Similarly, he said, "people don't get concerned about the overall market until they think the selloff has already started."

In essence, investors' fears of future volatility are what tend to boost the VIX Index, which is why the VIX Index is often referred to as the market’s "fear gauge."

Putting the Numbers in Context

Historically, the VIX hovers near 20, with its long-term median of 18. When the VIX drops below that, the market is considered to be undergoing an "abnormal" period of calm, while levels above 18 generally indicate higher market stress.

"As it gets further away from 20, it gets more and more abnormal," said Callie Bost, a listed derivatives analyst at TABB Group, a financial markets research and advisory firm.

For context, the VIX Index soared to around 80 in 2008 in the midst of the financial crisis. In July 2014, the VIX Index fell to about 10. More recently, the VIX Index has hovered between 14 and 16.

Bost notes that most of the time, the VIX Index’s movements are inversely correlated with that of the S&P 500 Index. For instance, when the S&P 500 Index is rising, investors may feel less urgency to hedge their positions, options become less popular and hence cheaper, and the VIX Index may drop.

Sometimes, however, the VIX Index and the S&P 500 Index move in tandem. This may have to do with how some market participants feel about events expected to unfold a few weeks down the road, such as an anticipated interest rate hike by the Federal Reserve. So even if Wall Street is enjoying an up day, some may feel the need to hedge their investments in anticipation of future moves by the Fed, prompting them to buy options, potentially fueling an increase in the VIX Index.

"If you're an individual investor, the VIX is a great sentiment indicator of the market," Bost said. "You can watch the stock market and say, 'This is what traders are thinking right now, but you can look to the VIX and say, 'This is what traders think of the market environment one month from today.'”