When you see a panicked market, how do you measure the fear? VIX helps you to do just that. CBOE introduced Volatility Index (VIX) in 1993. It is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. VIX indicates how fearful and volatile the stock market is.

VIX provides minute-by-minute snapshot of expected stock market volatility over the next 30 calendar days. VIX is calculated from the prices of S&P 500 options for various strike prices. More details and sample calculations are here.

VIX reached the record close of 80.86 in November 2008 at the height of economic crisis. It’s now close to 43. Not long ago, anything above 30 indicated high level of fear. VIX hasn’t closed below 30 in the last four months. Understanding of VIX would help you to gauge the market fear and take the appropriate investment decisions.

When the VIX is high, the stock options are priced higher. For example, if the VIX is at 25, Google March 300 calls may be priced at $23. Right now, Google March 300 calls are trading at $37.50 with the VIX at 43. This is a simplistic example – in reality, the option pricing is also depending on stock’s implied volatility. If you are an option seller, higher VIX would help you make more money. If you own stocks and want to write covered calls on the stocks, higher VIX would fetch you higher option premium. On the other hand, if you want to buy puts to protect your stocks, higher VIX would make you to pay more for put option premium.

When the VIX climbs higher, the general sentiment is that market is reaching the bottom. Traders used to believe that with all the fear in the market, there would be some kind of capitulation. That theory was proved wrong in the last few months. VIX keeps climbing higher; there is no sign of capitulation.

VIX is the good indicator to see the market trend. I personally use VIX to decide whether to sell options. Higher VIX inflates the option premiums and provide a good opportunity to sell put or call options.

CBOE introduced VIX options in February 2006. You can bet on VIX direction and buy/sell options on VIX. You can also use VIX options to hedge your investments against any future volatility. Stock options expire on third Friday of each month. However, VIX options expire on third Wednesday of each month.

If you are anxious about when the stock market carnage would end, keep watching VIX – the fear factor.

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