What is the Volatility Index (VIX), and How do I Use It?
The CBOE S&P 500 Volatility Index (VIX) -- often just referred to as the "VIX" -- is a gauge of future (predicted) volatility for the S&P 500 over the course of the coming 30 days. It's based on the price of a basket of S&P 500 index options ... puts as well as calls. The theory is, if option prices rise, then the rise in premiums suggests traders are positioning for a significant move.
The index theoretically should rise whether the market is expected to rise or fall within 30 days. In reality, the VIX behaves differently when traders are expecting bearishness rather than bullishness. Specifically, the VIX rises when traders are fearful a pullback is looming, and the VIX remains low when traders are feeling bullish about the foreseeable future. For that reason the VIX has become known as a "fear gauge," reaching higher levels when investors are most fearful.
Still, the S&P Volatility Index has tremendous use as a trading tool, and a contrarian tool in particular.
A contrarian strategy simply means a trader is bullish when the market is most bearish, and is bearish when the market is most bullish. The strategy works too, as extreme optimism and extreme pessimism are usually seen, respectively, and major market tops and major market bottoms. This means contrarians are actually buyers when the VIX is high (when fear is high). A low VIX also tends to coincide with an overbought market that's ripe for a pullback, though VIX-based pullbacks are tougher to pinpoint due to the market's inherent tendency to rise.
An example will illustrate how the VIX can serve as a trading tool. On the chart below, you'll see all the (relatively) high points for the VIX coincide with trade-worthy lows for the S&P 500. Though a little fuzzier, trade-worthy tops also took shape when the VIX was at unusually low levels.
SPX & VIX Daily Chart
Clearly there is no absolute high or absolute low level at which the VIX marks a turning point for the broad market; the application of Bollinger bands can help mark the relative highs and lows for the Volatility Index, though.
iPath S&P 500 VIX Short Term Futures ETN (VXX) is an ETF that looks to replicate the short-term VIX futures contracts -- it is used by many investors & traders as an easy way to access the VIX, however, this particular VXX ETN has had a downward bias over time that isn't necessarily present in the VIX, so keep that in mind.
It should be noted that other volatility indices are available for analysis. Traders may also wish to monitor the NASDAQ Volatility Index (VXN) and the Dow Jones Volatility Index (VXD), just to name a few. The Chicago Board of Options Exchange even maintains volatility indices on some of the market's most traded stocks like Apple (AAPL), and Amazon.com (AMZN).