Track Market Volatility With the VIX

When investors become anxious and worried about the stock market, many of them buy put options on the S&P 500 to hedge against a possible downside. If enough investors are fearful, the demand for puts increases and so does their price. But not all options investors are pessimistic, so some of the optimists buy call options betting that the market will rise.

This tug of war between the two sentiment camps can be quantified and one such measure is the CBOE Volatility Index, or VIX (^VIX), which reflects the real-time put and call option activity on the S&P 500.

The algorithm used to compute to VIX is quite complex, but the VIX is fairly easy to interpret. For any moment of every trading day, the value of the VIX is somewhere between 5 (volatility can not be zero) and 100. A value under 20 indicates that investors believe the market is headed to the upside. But a value above 30, indicates that investors think that the market is headed to the downside.

High values typically occur during times of political, economic and financial uncertainty. Low values indicate less turbulent times.

VIX and S&P 500 Long-term Trends

The multi-year relationship between the VIX and S&P 500 is rather complicated. Sometimes their trends move in the same direction, but often they do not.

VIX and S&P 500 Trends For 2007

The chart of daily closes for 2007 shows a general inverse relationship between the VIX and the S&P 500. Usually high values of the VIX have occurred when the market was going down or was at a low. And low values were associated with local tops. These relationships are not unique just for 2007; they hold for many short-term time periods.

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Posted December 7, 2007.