Stock market investors are well known for avoiding excessive risk and looking for maximum opportunity at minimum risk. In the financial markets in recent decades it has become standard to use volatility metrics for assessing how volatile, and hence how risky, a market is. On the SP500 index there is the Option Volatility Index (VIX) which specifically shows the expected volatility for this stock index for the next 30 days. Traders use this index as a gauge for expected volatility for the next 30 days, but the same volatility index (VIX) can be used on all US stock markets.
The Option Volatility Index is all about measuring risk.
As markets become more volatility their daily trading range increases dramatically, and the VIX index rises. But it also has an inverse relationship to the stock market itself. When stocks rise the VIX index falls, and when stocks fall the VIX index rises. This relationship lies on the fact that generally markets fall faster than they rise, since a stock market rally is about certainty. Whereas a stock market decline is about uncertainty and fear. And as with everything else in the real world, there are very few ways for things to go right, but too many ways for them to go wrong. Hence this asymmetry is what makes markets fall much faster than they can ever rise.
The relationship between stocks and the VIX indicator not only is an inverse one, but is also not always linear. Sometimes stocks can rally by X%, but the VIX index may not fall by a corresponding Y%, as expected based on its average historical value change. In fact it may actually remain unchanged or even rise on that very day. In such cases it is usually the VIX index that will prevail over the next few days, and the fact that it rose on a day where stocks rose is seen as a risk warning, as investors see a potential risk coming.
The VIX index is used by investors and traders as a rough gauge risk, it is not a perfect risk measuring index but one that sometimes can sense risk coming to the markets. The financial markets always tend to go up when there is little risk and when uncertainty is as low as possible. It makes little difference if the news to be released on any given day is good or bad, even bad news that is seen as ‘certain’ helps remove uncertainty and stock markets can actually rally on bad news days. Equally, good news days that come with unclear numbers and an element of uncertainty, are seen as ‘uncertain’ and stock markets can actually fall on such days.
All in all measuring risk in the financial markets, and in stock markets especially, is possible to some extend, through the use of the VIX indicator. There are many more ways to use the VIX index as an actual indicator for determining stock market direction, not just expected volatility over the next 30 days. But its main and basic use by investors and traders is that of a risk measurement indicator. When the VIX index is at historically high levels it is believed that stock markets will have larger daily trading ranges, and in fact that has been the case. Larger trading ranges means that the risk of a stop loss order being triggered is much greater, hence traders may opt to use larger stop loss orders or different, more sophisticated loss control strategies on their trades. They all usually involve stop loss and other contingent trade orders aimed at minimizing losses and maximizing profits based on these expected high volatility days. Direction-wise, traders expect the VIX index to fall as stocks rise, but this only works when the VIX is coming down from all time highs, and only for medium to short time frames. If stocks keep on rising for far too long, the VIX may in fact establish a sideways trading range where no new lows will be made even as stocks continue to make new highs. Hence this is one of the scenarios where linearity breaks down and more complicated patterns can appear.
The VIX index itself is a statistical reference, and is derived from statistical financial models. But it basically measures how much volatility is expected on the SP500 index over the next 30 days. The actual index value is in fact annualized and it shows the expected volatility for the entire year, but the initial calculations are based on the next 30 days only. As with all statistical figures it can be wrong, and that’s why it keeps changing on every trading day. The point is that through these daily fluctuations the VIX index can reveal whether investors are in a state of confidence or in a state of fear, or somewhere in between.