The Chicago Board Options Exchange Volatility Index, commonly known as the VIX, has secured a spot in the limelight as technical traders and six o'clock news broadcasters have religiously cited the measure throughout the unfolding economic crisis. The index is sometimes referred to as the "fear gauge" as it rises during times of increased market volatility.
While the magnitude of the VIX can parallel fear among investors in over sold markets, it also corresponds to positive sentiment in over bought market conditions. The measure is calculated by comparing the near-term to next-term options of the S&P 500 (SPX) to give a statistical measure of the potential change in the S&P 500 over the next 30 days. Dividing the VIX by the square root of 12 (representing the monthly % change) gives a rough percentage estimate of the potential change in the S&P 500 over the next 30 days.
Trusting the VIX currently trading at 37.46 to predict the potential change in the S&P 500 over the next thirty days, one would expect the index to fluctuate by roughly 10.8%. The trouble arises when the technical analysis is factored in with the real state of the economy and the firms it encompasses. When U.S. equity valuations are high with respect to growth the rational investor would expect the fluctuation to average on the downside. However, the sentiment of the market inspires players to become more hopeful or fearful with respect to recent moves in the security prices.
Take a look at the chart below, which compares the VIX to the S&P 500, to witness the simultaneous highs and lows of the two. While a low VIX does suggest less pessimism in the market, it can be dangerous to take an optimistic forward outlook in a market that still remains extremely volatile.
