Wall Street traders who want to estimate future market volatility often look to the Cboe Volatility Index or VIX. It basically is the measure of the level of implied volatility, and not statistical or historical volatility, of a wide range of options, based on the S&P 500. As Kavan Choksi points out, this indicator is commonly known as the “investor fear gauge,” as it reflect the best predictions of the investors of near-term market volatility or risk. VIX generally starts to go up during times of financial stress and tends to lessen as investors become complacent.
Kavan Choksi briefly talks about the need to keep an eye on the VIX (Volatility Index)
Volatility can majorly impact investment portfolios. Higher volatility levels can lead to larger price swings as well as increased risk. Keeping an eye on the VIX helps investors to assess the level of risk in the market and adjust their investment strategies as per its accordance. For instance, during periods of high volatility, investors may lower their exposure to more volatile assets or implement risk management techniques like hedging.
Implied volatility implies to the expected volatility of the underlying, which would be the diverse options on the S&P 500 Index in this situation. It represents the level of price volatility implied by the options markets. If implied volatility is high, the premium on options will be high, and vice versa. While there can be several other factors at work, a high VIX reflects increased investor fear and a low VIX suggests complacency in most situations. This pattern in the relationship between the VIX and the behavior of the stock market has repeated itself in bull and bear cycles historically. During the bullish periods, there is much less fear in the market, and hence the need for portfolio managers to purchase puts is low. By measuring the investor fear levels, VIX can be used as a contrary opinion tool in attempting to pinpoint market tops and bottoms on a medium-term basis, much like put/call ratio and sentiment surveys. There are two ways to use VIX for this purpose. The first one involves taking a look at the actual level of the VIX to determine its stock-market implications, and the second would be to look at ratios comparing the current level to the long-term moving average of the VIX. The second approach helps in removing long-term trends in the VIX, so as to get a more stable reading in the form of an oscillator.
As Kavan Choksi mentions, traders can always use the VIX as a tool to develop trading strategies. For instance, many traders employ volatility-based trading strategies that aim to profit from changes in market volatility. Traders can use the VIX as a signal to initiate or adjust their positions. The volatility Index can also be used in conjunction with other technical indicators in order to confirm or validate trading signals. Certain traders also consider the VIX alongside other fundamental and technical factors when trying to adjust their allocation across different asset classes based on their risk tolerance.