An often quoted rhyme to help new traders is... 'when the VIX is high, it's time to buy. When it is low, it's time to go.'
In reality, it is a lot more complicated than that. How high is high? How low is low? In the following chart, you can see that high and low are somewhat relative.
Until September 2008, we hadn't seen a level as high as it was trading in a very long time. In October 2008, we saw the VIX reach record levels.
I refer to this chart often to remind myself that there is no such thing as never.
The Volatility Index is basically a measure of the implied volatility of the S&P 500 index options, that is the options of the actual S&P 500 index. The formula for calculating it has changed once since its inception. However, the basis remains roughly the same. It takes into consideration the current price for OTM calls and puts for front month and back month options.
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The formula attempts to provide a number that represents the projected implied volatility of the S&P 500 index for 30 days. Curiously, the number is given as an annualized number. This means it is necessary to divide the number by the square root of 12 to get a projected % move for the coming 30 days.
Interpretation of this number is based on statistical probabilities. As an example, assume the current value is 40%. That value when divided by the square root of 12 (8.66%) represents the expectation that there is a 68% chance that 30 days from now, the S&P 500 will fall within a price window of plus or minus 8.66% of today's value.
The VIX is the volatility index for the S&P 500 and is the most widely referenced volatility indicator. There are also volatility indicators for the other indices like the DOW, Russell 200 index, NASDAQ, etc.
Frankly, I don't care too much how the number is calculated. I trust smart people are figuring that stuff out. I really use the Volatility Index in two primary ways.
Since the value changes every day and even intra-day, I can't really use it to determine a longer term bias. However, I can generally use it to determine if I'm likely to see a trend reversal. As such I'm using the relative range of movement to make a determination. I'll show you some examples.
While far from an absolute indicator, market reversals tend to happen on the extremes. Even within the larger moves, there are smaller moves, much like a stock would move. Keep in mind this is a contrarian indicator so lows here represent areas where there is a likelihood of the S&P 500 selling off... at least short term. Areas of extreme highs represent the potential for the S&P 500 to rally.
Notice though that the VIX tends to run in ranges for periods of time. In the above example we see that the range is generally between 16 and 30 for most of 2007 and 2008.
Yet, beginning in the fall of 2008, the range was much larger. Initially, there was a large move from the lows around 20 to a high of 80. Then, for a while it ranged between 50 and 80 before falling into a range between 40 and 55.
As a trader, I look at the recent moves from the highs around 55 and I expect to remain short term bullish until lows of 40 are reached. If at that point, the VIX falls below 40, I will continue to be bullish.
The other use I have for the Volatility Index is as a confirming indicator. There are times when a given day will begin with a move up or down. Usually, a move up will be accompanied by a move down of the VIX and visa versa. When this doesn't happen, I become a little suspicious of the move of the S&P. This can create opportunities for intra-day trades or give me reasons to remain in a trade even though the market appears to be moving against me.