What is the VIX and Why is it Significant?
In trading and investing one will often hear the term VIX and Fear Index used interchangeably. The VIX is an expected measure of price volatility in the US S&P 500 over the coming 12 months. It is derived from ratio of put (bearish) option volumes to call (bullish) option volumes using their premiums as a measure of risk. So a VIX of 26 implies a potential price variation of the S&P 500 over the coming year of +/- 26% at one standard deviation or 68% (normal distribution confidence curve) : i.e there is a 68% change that price will lie within +/- 26% of the current value over the coming year.
Clearly the higher the VIX the higher the expected risk . While the VIX is often used as a leading indicator, extremes of the VIX are often contrarian indicators. So for example, recent very low VIX values around 10 or even below were signs that little protection was being sought and that traders and investors were extremely complacent. The converse is true, when VIX scores spike higher this reflects high degrees of implied volatility which are unlikely to continue. This does beg the question, what is a "normal" VIX value. That in turn depends on the underlying market volatility. When I first started trading full time in 2010, normal VIX values were around 20 as markets were skittish and investors nervous following the fallout of the GFC: the Figure below shows how VIX was hugely elevated during the financial crisis in 2009 with values up to 80.
In more recent years as global QE has swamped markets, volatility has tailed off particularly with EFT and program buying as passive investing has become more prevalent and investors more sanguine. Recent more "normal" levels of VIX have been below 20 and around 15 with frequent VIX levels of 12.