Stock market volatility is one of the most misunderstood concepts in investing. But it’s an important — and profitable — tool for analyzing certain stocks and the broader market.
The most popular tool to measure stock market volatility is the CBOE Volatility Index, also known as the VIX.
But what is the VIX and how does it work?
The VIX Is Also Known as the ‘Fear Gauge’
To start, the VIX is known and works as Wall Streets “fear gauge.” It is the range of price changes the market or individual stocks experience over a given period of time — how volatile they are.
If prices stay relatively stable, a market or stock has low volatility. A highly volatile market or stock can reach new highs and retreat quickly, meaning they move erratically and have rapid increases and dramatic falls.
Most investors tend to experience the pain of loss more acutely than the happiness of a gain. So a volatile market or stock that moves down as often as it moves up may seem like too risky a bet to some.
However, what seasoned traders know that average investors may not is that stock market volatility provides a ton of moneymaking opportunities for those who are patient. Investing is all about risk, but risk works both ways.
Each trade carries the risk of both failure and success. Without volatility, there is little risk of either.
What Is the VIX and How Does it Work?
There are a number of ways to measure volatility, such as exchange-traded funds (ETFs) and exchange-traded notes (ETNs).
As mentioned above, the tool most often used is the CBOE VIX Volatility Index (VIX). This is an index that typically trades around the 20-point level, which means average volatility. Average volatility is when an index or stock moves up or down about 1% on any given trading day.
If you’d like to learn more about how to track volatility with the VIX index, click here.
The VIX works as a real-time index that represents the stock market’s volatility expectations over a 30-day, forward-looking period. The index is derived from the price inputs of S&P 500 index options, and provides a measure of market risk and investor sentiment.
Investors, research analysts and portfolio managers look to VIX values as a way to measure risk, fear and stress before they make decisions.
That, in a nutshell, is the VIX and how it works.
For you math whizzes out there, here’s a chart of how the VIX is calculated…
Volatility in the Face of a Pandemic
For 2020, the VIX traded to a January low of 11, when the stock market (and U.S. economy) were breaking records. Times were good before the coronavirus pandemic began garnering major attention.
Over the next few months, as the economy shut down and the stock market fell 40% to 50% from its peak, the VIX zoomed to a high of 85 by mid-March. Since the baseline score for an index to move up or down up to 1% on any given trading day is 20 — which is considered average — 85 means things are extremely volatile.
In fact, although not many experts predicted a major stock market rally off the March 2020 lows, the VIX was near its highest levels in history at 85. The all-time intraday record high was 89.53, set on Oct. 24, 2008 — the crest of the biggest financial crisis since the Great Depression.
As the stock market began to rally, volatility remained elevated through April and May, trading in the 30-40 range.
Over the summer and into the last trading day of August, as the stock market returned to record highs, the VIX traded around 21. As September wound down, the fear gauge shot up to 38, meaning volatility increased sharply, giving us further illustration of how the VIX works, particularly amid global events that shock the system.
Trading the VIX Works as a Hedge
While the VIX has been around since the 1970’s, other volatility-based securities that track the index have been introduced over the past decade. They have proven to be popular with investors, for both hedging and directional investments.
The buying and selling of these types of ETFs or ETNs have had a significant impact on the functioning of the original VIX index, which has been transformed from a lagging indicator into a leading indicator.
However, most talking heads only pay attention to the indicator when it is high.
Aside from the VIX, other major volatility funds include:
- iPath Series B S&P 500 VIX Short-Term Futures ETN (AMEX: VXX)
- iPath Series B S&P 500 VIX Mid-Term Futures ETN (AMEX: VXZ)
- Pro-Shares VIX Short-Term Futures ETF (NYSE: VIXY)
- Pro-Shares VIX Mid-Term Futures ETF (NYSEArca: VIXM)
Overall, volatility can be a good indicator for the stock market and traders looking for big price swings that can lead to short-term profits. So understanding what the VIX is and how it works is helpful to every trader.
Of course, more in-depth technical knowledge on indicators like strength indexes, volume and established support and resistance levels are needed to be most successful.
Click here to see my go-to trade for when markets get volatile!
Senior Strategist, WealthPress