The VIX Index is the Chicago Board Options Exchange future volatility measure for the S&P 500. There are three different types of volatility indexes - the VXN for the Nasdaq 100, the VXD for the Dow Jones Industrial Average, and the VIX for the S&P 500. This volatility index shows the market’s expectations for the next 30 days and is calculated from both calls and puts.

What does the VIX Index do?

The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge".  When it was first introduced in 1993 by Professor Robert E. Whaley, the index measured the expectations for eight of the S&P 100 companies. Since then, it has expanded to include all of the companies in the S&P 500. This allows for a more accurate measure of the market’s future.

How does the VIX predict the market risk?

The Chicago Board Options Exchange has a formula that is used to determine the market’s future. The formula includes the stock’s volatility, or the extent to which the stock has changed over the past year. This number is measured in a percentage. The more volatile a stock is, the more expensive it will be. However, prices will change based on supply and demand. So the formula allows for the volatility to be separated from the price to correctly determine the future.

Why is understanding the VIX important?

The VIX determines how much people are willing to pay for a stock, which essentially is measuring the future state of the economy. In general, the VIX starts to rise during times of financial stress and lessens as investors become complacent. It is the market's best prediction of near-term market volatility. VIX values greater than 30 are generally associated with a large amount of volatility as a result of investor fear or uncertainty, while values below 20 generally correspond to less stressful, even complacent times in the markets. When the economy is doing well the VIX tends to have a lower number, but it rarely goes below 12 or 13. A low number can also indicate the possibly that the market is reaching its maximum and people are getting ready to sell to make large profits. When the VIX index is high, around 40 or above, the economy is in a weak state. A high number can indicate that fear has reached its potential and the market is getting ready to turn back up.

Therefore, watching the VIX index will help you decide what is best for you to do with your stocks in the near future.  Just remember, even though benchmarking the past is a solid way to determine the future, nothing is set in stone.