What You Need To Know About the Volatility Index, Otherwise Referred To as the VIX - Part 1
Part 1: Why is the VIX (Volatility Index) an Important tool for Investors?
The VIX explained: Few really know what the Volatility Index is or how it is calculated. Here's are two brief explanations ... the first is a technical explanation, and the second is a description that investors can easily understand.
First, a brief technical explanation ... The Volatility Index (or VIX) is a weighted measure of the implied volatility for real time $SPX put and call options. The puts and calls are weighted according to time remaining and the degree to which they are in or out of the money. From this is created a hypothetical at-the-money option with a 30 day expiration time period. In this way, they are trying to set a value that is equal to the equivalent value of the $SPX's current price. (When a stock's option strike price is "at the money", it is theoretically the same as the price the stock is trading for at that moment.) So what does that mean? It means that the VIX really represents the "implied volatility" for the hypothetical $SPX put/call options on an "at the money" option value.
Second, a brief understandable explanation ...
Simply put, the VIX is a key measure of market expectations in the near term. For almost 20 years, the VIX has been considered as a valuable barometer of investor sentiment and volatility. Another way to look at it, is that it measures perceived risks of investors. The greater the perceived risks investors have about stocks, the more they buy "protection Put options", which means that the VIX will therefore be moving higher. When the VIX moves higher, the market moves lower because they are inversely related.
Many talk about the VIX's implied volatility changes ... but, don't get caught up about the term "implied volatility" if you don't understand it. What is important is that the VIX moves up during times of uncertainty or fear, and down during times of greed or confidence. Since the VIX moves in the opposite direction of the market, you can know what to expect for upcoming market movements by observing what is happening to the VIX. If you think about it, the VIX is a good example of "the self fulfilling prophecy". (The definition from Wikipedia is: "A self-fulfilling prophecy is a prediction that directly or indirectly causes itself to become true, by the very terms of the prophecy itself, due to positive feedback between belief and behavior.")
How does it work as a self-fulfilling prophecy? Imagine that an investor has bought a lot of equities over time and now believes that market risks are rising, so he feels that it would be wise for him to buy protective Put options in order to protect his equity. If he believes the market risks are truly rising, he not only buys the Puts, he also stops buying ... otherwise it would be counter-productive. The mere action of enough large investors stopping their buying is often enough for the market to be unable to sustain its up movement. Thus the market pulls back a the self-fulfilling prophecy event occurs.
**NOTE** Since investors have to buy options expiring in the future in order to protect themselves from their perceived beliefs about upcoming changes in the stock market, those actions cause the VIX to move ... and the VIX's movement therefore measures investor expectations of what they believe will happen in the near future. That's it ... this is all you need to know about what the VIX really is.
Since the VIX reflects the actions of investors who buy options as insurance against losses on their current portfolio positions, it would suggests that the VIX's action is predicated on the actions of some very knowledgeable, as well as some very large investors.
So, should you learn more about the VIX and use it ... or not? Here is what you need to ask yourself and decide about: Is the VIX a reliable measure for me to use in determining what will happen to the stock market or not?
If it isn't, then simply disregard it and do NOT use it as an important tool for making investment decisions. HOWEVER, if it is, then you MUST consider using the VIX as a tool when making investment or trading decisions.
I know that you cannot answer this question without also knowing how the VIX tracks with the Stock Market, and how to use the VIX in an effective manner. So, within a week, we will post Part 2 of this Series on the VIX. The title of Part 2 on the VIX will be: "How to Use Technical Analysis on the VIX to know when the market will change direction."