John Jagerson

Predicting Volatility With the VIX

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Trader expectations as shown on the VIX are directionless. In the example above we can understand that traders are expecting a 2.5% move in one direction or the other, but not specifically up or down. However, because unexpected market volatility is biased to the downside, a rising VIX is usually associated with bearish expectations. Remember that the market doesn't crash up; it only crashes down.

That means that if traders are expecting a lot of volatility, it is generally a bearish sign. That is one of the reasons the VIX is often called a measure of fear. If investors are concerned that volatility is increasing, the VIX will rise. Conversely, if investors are expecting low volatility, the VIX will drop, and that is considered bullish. This rule is generally true, but you will see exceptions on a day-to-day basis. We will talk about that more in the next article in this series.

The implications here are obvious. If the VIX is falling, investors are trading bullish strategies and taking on more risk. If the VIX is rising, traders may be shorting the market and trying to limit risk within their portfolio.

Because the VIX is typically range bound, traders are particularly interested in periods when the index is hitting support or resistance levels.

How bearish or bullish traders feel based on the VIX index is important because it indicates what is going on with attitudes toward risk. Recently, increases in investor fear have been associated with falling stocks, rising bonds and a stronger U.S. dollar. The same is true in reverse, as the VIX has been retreating from multi-year highs in early 2009.

The growth in interest in the VIX has spawned other volatility indexes that track oil, gold, the EUR/USD exchange rate and other stock indexes. (Learn more about trading gold and commodities.) These are also very helpful and you will learn more about them in the next article in this series.

This article originally appeared on the Learning Markets Web site.