The last couple of days have made it abundantly clear, volatility is still the name of the game in the stock market right now. Consecutive days of a loss of 335 points and then a gain of 279 points on the Dow used to be a very rare occurrence but now it is simply become the norm.

What exact does this volatility in the stock market tell us about the current state of the economy and the confidence of investors? It tells us that investors are very uncertain about what is next for the economy and at this point they are unable to make any stable hypothesis as to when things will get better. Rather than a stable market that tries to find its footing we have a market that is full of uncertainty and is as fickle as any market in decades. One day investors may be encouraged that things may not be quite as bad as they feared, while the next it feels as if the sky is falling.

What should the average investor do in this kind of environment? The key is to not read too much into daily movements of the market. The wild swings up and down are likely to continue, but until the volatility begins to level off it will be very difficult for the individual to make money in the stock market. It is fair to say that in a period with so much uncertainty and so much volatility there is a much greater risk to the average investor than there is reward.

This doesn’t mean you can’t invest in anything or you shouldn’t be doing your homework on companies you might invest in sometime down the road. It is always a good idea to be ready for the time when it comes, but also realize that turning the calendar into January has done nothing to change the sentiment of the market. Tread with extreme caution during these volatile days.

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.

Related Links: VIX options guide | Economy in free fall