There has been a lot of talk lately about the Volatility Index commonly called the VIX. Investors often look at the VIX to determine how much fear there is in the markets. For a prolonged period, 2004-2006, the VIX traded at very low levels. For most of those years, it traded well below 20, suggesting not only that investors had little fear of risk, but also that they were complacent. However, the VIX started rising in 2007. It peaked in late 2008 above 80 as the financial crisis made front-page news.
Recent talk of the VIX has focused on its rapid decline. It is now below 30, yet still well above the 2004-2006 levels. This suggests investors have become less fearful of putting money at risk, but they are still far from being complacent.
The VIX is actually the instantaneous standard deviation from the Black-Scholes Option Pricing Model. Traders sometimes use this model to identify overvalued or undervalued options. The model relies on several variables, one of which is the underlying stock's instantaneous standard deviation. This variable is almost impossible to measure. However, if all the other variables are known, the standard deviation can be backed out of the Black-Scholes equation. In the case of the VIX, the underlying stock is actually the S&P 500 Index.
The VIX tends to rise when the market sells off, but it falls when the market rallies. In other words, it is a better measure of downside volatility than overall volatility. Furthermore, the VIX is not a reliable forecaster. The market does not rally simply because the VIX falls. In fact, it is more accurate to say that the VIX falls as the market rallies.