The VIX index is one of the most important indicators in the financial markets. Often called the "fear index" or "fear gauge," it measures expected market volatility over the next 30 days. Understanding the VIX can help you make better trading decisions and manage risk more effectively.
What is the VIX Index?
The VIX, officially known as the CBOE Volatility Index, measures the market's expectation of 30-day forward-looking volatility. It is derived from the prices of S&P 500 index options and represents the expected annualized change in the S&P 500 over the next month.
The simple version: When the VIX is high, traders expect big price swings in the market. When the VIX is low, traders expect calm, steady markets. It does not predict direction, only the magnitude of expected moves.
How is the VIX Calculated?
The VIX calculation is complex, but the basic idea is straightforward. The CBOE takes the prices of a wide range of S&P 500 put and call options across multiple strike prices and expiration dates. It then uses a formula to calculate the expected 30-day volatility implied by these option prices.
Key points about the calculation:
- Uses both put and call options on the S&P 500
- Includes options expiring between 23 and 37 days
- Weights out-of-the-money options more heavily
- The result is expressed as an annualized percentage
What VIX Levels Mean
Understanding VIX levels helps you gauge market sentiment and adjust your trading accordingly.
VIX Level Guidelines
- Below 12: Very low volatility - market is extremely calm, complacency may be high
- 12-20: Normal volatility - typical market conditions
- 20-30: Elevated volatility - increased uncertainty, some fear in the market
- 30-40: High volatility - significant fear, often during corrections
- Above 40: Extreme volatility - panic selling, major market stress
The VIX and Market Relationship
The VIX has an inverse relationship with the stock market. When stocks fall sharply, the VIX typically spikes. When stocks rise steadily, the VIX usually declines. This relationship is not perfect, but it holds true most of the time.
This inverse correlation exists because:
- Investors buy put options for protection when they fear declines
- Increased demand for puts raises option prices
- Higher option prices translate to higher implied volatility
- The VIX rises as implied volatility increases
Why the VIX Matters for Traders
The VIX provides valuable information for different types of traders:
For Options Traders
Options are priced based on implied volatility. When the VIX is high, options premiums are expensive. When the VIX is low, options are relatively cheap. This affects which strategies work best:
- High VIX: Favor selling premium strategies like credit spreads and iron condors
- Low VIX: Favor buying options strategies like straddles and debit spreads
For Stock Traders
The VIX helps gauge market sentiment and potential turning points:
- VIX spikes often coincide with market bottoms
- Extremely low VIX readings can precede corrections
- Use VIX trends to adjust position sizes
Trading the VIX
You cannot trade the VIX index directly, but several products let you gain exposure to volatility:
VIX Futures
VIX futures trade on the CBOE Futures Exchange. They represent the expected VIX level at a future date. Important to understand: VIX futures do not perfectly track the VIX spot index.
VIX ETPs (Exchange Traded Products)
Products like VXX, UVXY, and SVXY provide volatility exposure:
- VXX: Short-term VIX futures exposure
- UVXY: 1.5x leveraged VIX futures
- SVXY: Inverse VIX futures (profits when volatility falls)
Warning: VIX ETPs suffer from contango decay and are designed for short-term trading, not long-term holding. They can lose significant value over time even if the VIX stays flat.
VIX Options
Options on VIX futures allow for more sophisticated volatility strategies. These are European-style options that settle to cash based on a special opening quotation.
VIX Trading Strategies
Mean Reversion Strategy
The VIX tends to revert to its long-term average around 18-20. When the VIX spikes to extreme levels, it typically falls back. Traders can:
- Sell VIX calls when the index spikes above 30
- Buy inverse VIX products during extreme fear
- Use put credit spreads on VIX when elevated
Contango Play
VIX futures are usually in contango (futures above spot). This means VIX ETPs like VXX lose value over time as they roll futures. Some traders consistently short these products to capture this decay.
Hedging Strategy
Long VIX positions can hedge a stock portfolio:
- Buy VIX calls as portfolio insurance
- The VIX position profits during market crashes
- Offset some losses in your stock holdings
Common VIX Mistakes to Avoid
- Holding VIX ETPs long-term: They decay significantly over time
- Ignoring the term structure: Check if futures are in contango or backwardation
- Using VIX to predict direction: The VIX measures magnitude of moves, not whether stocks will go up or down
- Shorting during backwardation: When VIX futures are below spot, shorting VIX products is risky
VIX Term Structure
The VIX term structure shows future expectations at different time horizons:
- Contango: Future VIX higher than current - normal conditions, market expects calm
- Backwardation: Future VIX lower than current - stress conditions, fear is elevated now
The term structure shape provides clues about market sentiment and potential VIX direction.
Track Volatility in Your Trades
Pro Trader Dashboard helps you monitor implied volatility across your positions, identify when options are cheap or expensive, and time your entries better.
Summary
The VIX index is an essential tool for understanding market sentiment and volatility expectations. While it does not predict market direction, it tells you how much movement traders expect. Use it to adjust your strategies, size positions appropriately, and identify potential market turning points.
Ready to learn more about volatility? Check out our guide on implied volatility or learn about volatility crush and how to profit from it.