How to understand the Volatility Index (VIX)

The Volatility Index, also known as the VIX, is an index used to measure the volatility in the major stock market indices. What does the VIX tell us? When should you pay closest attention to the VIX?

Things You'll Need

• Basic understanding of stocks
• Basic understanding of risk

Instructions

1. What is the Volatility Index (VIX)? The Volatility Index is an index that is used to measure the market's expectations of volatility in the stock market in the next 30 days. The VIX was started in 1993 by the Chicago Board of Exchange and was first allowed to be traded in futures trading in 2004.

2. In order to understand exactly what the VIX understand is all about you must first understand the most basic definition of the word volatility. Volatility is defined as tendency to fluctuate sharply and regularly.

3. The VIX is used by many stock market traders to understand just how much fear or complacency there is in the overall market. A normal reading in the index is between 20 and 30. A reading under 20 typically means that most investors aren't worried at all and might be getting complacent. A reading above 30 generally means there is quite a bit of nervousness and fear in the marketplace.

4. 

   The Volatility Index is often used as a contrary indicator. How do traders use this as a contrary indicator? When the VIX spikes to extremely high levels it tends to mean a bottom in the stock market is nearby because panic selling has set in. On the other hand when the VIX goes to very low levels it usually means the current bull market may have a short shelf life remaining.

Tips & Warnings

• Understand that the VIX is based off of stock option trading, so it can have wild swing in it as well.

• A volatility graph is a good way to watch the trends in the VIX.

• The contrary indicator doesn't always work. Don't count on this alone as a buy or sell signal.