The Vix is driven by options trading and is calculated as a positive percentage and the expected volatility of the S&P 500 over the next 30 days. Rather than measuring the volatility in shares, the Vix instead measures the options market. As banks and hedge funds start to see signs of downside risk in the markets, they will move to mitigate risk by buying up options. The higher the expected swings in price, the higher the premiums charged by writers of options.
The Vix will usually trend around the 15-16 per cent area, but if there is some nervousness in the market, it will break above that. During the uprisings in the Middle East and north Africa this spring, we saw the Vix hit the 30 per cent area, peaking with the Libyan invasion over fears of a slow down in oil supply from the area. The index spiked again during the US debt stalemate. And if we see another major bank collapse or a Eurozone country default on its debt obligations, then we will see another big spike in the Vix. As such, the Vix can be used as a hedge against the S&P 500. If you think that the market is taking a complacent view to downside risk and the Vix percentage is on the low end of the scale, then you might choose to go long Vix.
The Vix is currently sat around the 30 mark, at the same time as a relative low in the S&P – indicating that nervous investors have driven up the price of options. This could be seen as a signal that we are set for a trend reversal, with a recovery in the S&P.
The fear index is not an exact science, but should help traders to be less scared of volatility.