Whether you’re a seasoned options trader or a novice investor, you’re likely aware that volatility plays a significant role in the market. Like many things, this can be quantified in the form of an indicator.

Also known as the “Fear Index,” the Volatility Index (VIX) is a contrarian sentiment indicator that helps to determine when there is too much optimism or fear in the market. The market typically reverses course when sentiment reaches one extreme or the other.

Let’s dive in further to understand how it works and why it matters for investors and traders alike…

What Is Volatility?

Before we address the VIX, we should understand that volatility simply refers to the rate and magnitude of price changes. So, in simple terms, volatility is how fast prices move.

When the market is calm and moving in a trading range or even has a mild upside bias, volatility is typically low. On these days, call option buying (a bet that the market will move higher) generally outnumbers put option buying (a bet that the market will go down). This kind of market typically reflects complacency, or a lack of fear.

Conversely, when the market sells off strongly, anxiety among investors tends to rise. As a result, traders rush to buy puts, pushing the price of these 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.

But remember, the VIX is a contrarian indicator. So when the market is showing complacency, you can bet that the mood will soon shift. Similarly, an oversold market filled with fear is apt to turn and head higher.

How The VIX Works

The VIX uses data from the CBOE, or Chicago Board Options Exchange. Each day the CBOE calculates a figure based on prices paid for near-term S&P 500 options (both puts and calls). This allows traders to get a sense of the “expected” volatility over the next 30 days.

The critical question the Volatility Index answers is “What is the ‘implied,’ or expected, volatility of the synthetic option on which the index is based?” We already know the following variables:

— The market price of the S&P 500
— The prevailing interest rate
— The number of days to the expiration of the option series
— The strike prices of those options contracts

The equation solves the “implied,” or expected, volatility. And since volatility is generally viewed as a way to measure market sentiment, this gives us an idea of whether investors are “fearful” or “complacent.” A higher value for the VIX generally signals a greater level of fear and uncertainty, while lower values signal complacency. Over the long term, a value of 20 is considered average, while 30 or greater is considered high.

How Traders Use The VIX

One helpful way to analyze the VIX in the near term is with a Bollinger band, which we have added to the chart below.

The market is overly complacent when the Volatility Index goes outside the upper Bollinger band. The market is overly fearful when it goes below the lower Bollinger band. A pullback within the band is a sign that the market is turning. A cross of the 20-period moving average around which the band is built signifies a coming overbought or oversold condition.

The current reading on the VIX is 19.98 as of this writing. That is one of the lowest readings we’ve seen in months. The (VIX) is also nearing the lower Bollinger band, meaning that complacency with the recent bear-market rally may be beginning to set in. This is potentially dangerous for traders and investors who are long stocks right now. However, we haven’t yet reached the extreme levels that might signal a turn is imminent.

Closing Thoughts

The Volatility Index works well with other market indicators. By studying its signals, traders can develop a better understanding of investor sentiment and possibly be able to anticipate reversals in the market.

But like many indicators, it is not foolproof and should simply be viewed as another tool in the toolbox.

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