The Volatility Index (VIX) is a contrarian sentiment indicator that helps to determine when there is too much optimism or fear in the market. When sentiment reaches one extreme or the other, the market typically reverses course seeking equilibrium.

What is volatility?

One definition describes volatility as “the rate and magnitude of changes in price.” When the market is calm and moving in a trading range or even has a mild upside bias, volatility is typically low. On these kinds of days, call option buying generally outnumbers put option buying. This kind of market reflects complacency or a lack of fear.

Conversely, when the market sells off strongly, anxiety among investors tends to rise. Traders rush to buy puts, which in turn pushes the price of options higher. This increased amount investors are willing to pay for put options shows up in higher readings on the VIX. High readings typically represent a fearful marketplace.

The VIX works well in conjunction with other “sentiment indicators”.

By studying its message, traders can have a better understanding of market sentiment, and thus possible reversals in the market.

The concept of computing implied volatility or an implied volatility index dates back to the publication of the option valuation model by Black and Scholes in 1973. The  Volatility Index was created by Robert E. Whaley of The Fuqua School of Business at Duke University. In 1992, the CBOE commissioned Robert Whaley to design a formula to compute implied stock market volatility based on prices from its S&P index options market. Based on his formula and the CBOE’s historical record of index option prices, Whaley computed daily VIX levels dating back to January 1986.

Although the  Volatility Index is often called the “fear index”, a high Volatility Index is not necessarily bearish for stocks. Consider that the VIX is a measure of market perceived volatility in either direction, including to the upside. When the market is believed as likely to soar as to plummet, writing any option that will cost the writer in the event of a sudden large move in either direction becomes equally risky.

Hence high VIX readings mean investors see a significant risk that the market will move sharply, whether downward or upward.

The highest VIX readings occur when investors anticipate huge moves in either direction. Only when investors perceive neither significant downside risk nor significant upside potential will the VIX remain low.

Historically speaking, the VIX below 20 means that the market is predicting a low risk environment. However, if the VIX falls too low, it reflects complacency and that is dangerous, implying everyone is bullish. If the VIX heads higher than 20, then fear is starting to enter into the market and it is predicting a higher risk environment. The VIX is not set by any one person or even groups of people; it is solely determined by order flow of all buyers and sellers of options.

The VIX is a helpful tool and indicator. It gives a current and accurate measure of where options premium in the S&P 500 index is trading.  It is driven more by the perception and human condition of fear and greed, than by any other force.

Join Robert Roy every week in his Market Review and in Power Hour to discuss the S&P 500 along with the VIX Index.