You might hear your friends and relatives who actively trade stocks and mutual funds talk about the “VIX.”
It sounds like a ticker for a stock or fund, but it’s just an abbreviation for “volatility index,” a measurement of how volatile stocks are likely to be in the very near term.
The VIX is created using complex financial modeling of options trades on the S&P 500 Index of stocks, which tracks the 500 largest U.S. companies by market capitalization.
Options traders constantly project the future valuations of these stocks in an ongoing process of trying to buy or sell options contracts.
Being right about the direction of a given stock allows a successful options trader to capture that upside without having to own the position itself. It’s a form of leverage.
While estimations of stock prices at the individual level amounts to fancy guesswork, enough guesses in a given direction can suggest that stock prices as a whole are likely to go up or down with more frequency in the weeks ahead.
The Chicago Board Options Exchange (CBOE) measures all those guesses and creates the volatility index to reflect the collective anticipation of options traders for the next 30 days.
The resulting data is then compared to the historical volatility of the same stocks. The difference between these data points provides a view into how much traders think stocks will move in the short term.
Known in the financial press as the “fear index” or “fear gauge,” the VIX can be traded against, but it also provides active investors with an idea whether a stock they own or want to own (or perhaps want to sell) might present an opportunity to trade in the short run.
For the long-term investor, however, the activity of the VIX is more valuable as a form of investing gossip than as a trading tool. Regular contributors to retirement plans, for instance, are unaffected by short-term swings in market activity.
The best way to dampen the potential emotional effect of periods of market instability is to contribute a fixed amount to your investments, a process known as dollar-cost averaging.
As the months and years pass, the volatility of any given 30-day stretch will be remarkably unimportant. Steady contributions and compounding smooth out that short-term market noise until it’s irrelevant to your outcome.
MarketRiders, Inc. is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and, unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Past performance is not indicative of future performance.