Decoding the Volatility Index (VIX) and Its Market Impact

The CBOE Volatility Index (VIX) is a measure of expected price fluctuations in the S&P 500 Index options over the next 30 days. The VIX is often referred to as the “fear index.” It’s calculated in real time by the Chicago Board Options Exchange (CBOE).

The predictive nature of the VIX makes it a measure of implied volatility. It’s not based on historical data or statistical analysis. The time period of the prediction also narrows the outlook to the near term.

Understanding the Relationship Between the VIX and the S&P 500

It’s Not Instant

The VIX is considered a reflection of investor sentiment, but one must remember that it is supposed to be a leading indicator. In other words, it should not be construed as a sign of an immediate market movement.

For example, on Nov. 9, 2017, the VIX climbed 22% during the trading session on fears of delays in the tax reform plan. Meanwhile, the S&P 500 was down less than one percentage point.

Although the VIX revealed high levels of investor anxiety, the Investopedia Anxiety Index (IAI) remained neutral. The IAI is constructed by analyzing which topics generate the most reader interest at a given time and comparing that with actual events in the financial markets. It breaks down investor anxiety into three distinct categories—1. Macroeconomic; 2. Market; and 3. Debit and credit.

It’s Not Perfect

The VIX is considered a reflection of investor sentiment and has in the past been a leading indicator of a dip in the S&P 500, but that relationship may have changed in recent times. For instance, in the three months between Aug. 8, 2017, and Nov. 8, 2017, the VIX was up 19%—seemingly suggesting anxiety among market participants and implying that the S&P 500 should be on a downward trajectory. However, the S&P 500 was busy scaling all-time highs during that time frame.

Meanwhile, the IAI, which also has proven to be a leading indicator to the VIX, has shown some divergence. During the time period mentioned above, despite some concerns about the market, the overall IAI actually moved lower.

The Bottom Line

Sentiment plays a big role in decision making for the stock markets, and to that extent, it could be a good idea to glance at the VIX. However, the index is far from perfect, and investors should consider how much weight they want to peg on it.