The Chicago Board Options Exchange (CBOE) Volatility index (Vix for short) was created in 1992 by finance professor Robert Whaley, based on the academic work of Menachem Brenner and Dan Galai.
The Vix is calculated using the weighted average prices of various options on the S&P 500 index. Options give buyers the right (but not the obligation, hence the name) to buy (“call”) or sell (“put”) the index at a certain price. So they can be used to bet on the market moving in one direction, or to “hedge” a portfolio against short-term adverse moves.
One factor affecting option prices is the expected level of volatility (the more volatile the market, the more likely it is that the option will end up “in the money” – ie, worth something). So the Vix reflects how volatile traders expect the market to be over the coming year – broadly speaking, above 30 represents high volatility, while below 20 suggests calm.
Some argue that the Vix works well as a contrarian indicator – a low Vix indicates that traders expect calm conditions to continue, and are thus overly complacent, suggesting that stocks should fall (leading to the nickname, “the fear gauge”). However, most studies have shown the Vix to be a coincident indicator (ie, it shows what’s happening right now) rather than any use as a forecasting tool, contrarian or otherwise.
Equally, the Vix can rise alongside stocks – sharp moves can happen to the upside as well as the downside. One problem with trying to trade the Vix is that exchange-traded products that are “long” the Vix tend to lose money over time, because of the cost of “rolling over” the underlying futures contracts on which they are built. This is one reason why shorting the Vix has become so popular. However, this carries its own risks, which will only become ever more important as less experienced traders pile in.