Background: The idea for an index to measure the volatility of the stock market was conceived in the late 1980s and was introduced by the Chicago Board Options Exchange (CBOE) in early 1993. The index was originally based on the S&P 100 Index option prices (OEX) traded at the CBOE, but the underlying index was changed to the CBOE S&P 500 Index (SPX) in 2003.

Computed on a real-time basis, the VIX is quoted in percentage points and indicates what the market expects the movement in the S&P 500 Index (SPX) will be in the next 30 days.

Although most technical indicators can be applied to a range of markets and are not a trading instrument themselves, the VIX is just an indicator of S&P 500 Index volatility and is also the basis for a futures contract, started in 2004, an options contract, started in 2006, and exchange-traded funds.

Purpose: The VIX is often referred to as the fear index because it reflects the trading crowd’s opinion of stock market price movement. High VIX readings indicating expectations for greater volatility — that is, wilder and sharper market swings — are typically associated with falling stock market prices but could also be the result of sharp increases in stock prices.

VIX has become the best-known gauge of investor sentiment for stock market investors and, as such, could also be included in the sentiment category of indications. VIX provides a key reading for options traders.

Basic signals: A rising VIX reading suggests greater volatility and uncertainty in the stock market. The could also produce a decline in such markets as oil due to expectations for slower economic growth and increases in the price of markets such as gold or T-notes as value havens.

An average or normal VIX reading, if there is such a thing, is around 18-20. If VIX drops below that level, it indicates traders are complacent and traders should buy options because premiums are lower. If VIX spikes to 30 or higher, it indicates traders are fearful and uncertain and suggests traders should be sellers of options as premiums are higher.

VIX reached a high of nearly 90 during the steep stock market setback in the fall of 2008 but has also been as low as 10 (see chart below).

Pros/cons: VIX does not measure price but what the market thinks will happen to SPX prices in the near future. It is a good tool for options traders to determine whether they should be buyers or sellers, but it can also be a very short-lived reading of investor sentiment at the moment. Spikes from low levels and collapses from high levels can be devastating for those who trade the VIX instruments.