Whenever you start seeing the Cboe Volatility Index ($VIX) featured in financial media headlines, you know the market environment is getting turbulent. Also known as the “fear index” or “fear gauge,” the VIX is widely referenced as a touchpoint for investor sentiment. Generally speaking, a higher VIX means investors are panicking - while a lower VIX corresponds with periods of relative calm on Wall Street (remember those…?).

For the uninitiated - or anyone who just needs a refresher - learn more below about what is the VIX, how it’s calculated, how you can trade its big directional moves (and whether you should), and how this closely followed metric impacts your portfolio.

What Is the “Fear Index”?

Just as the name suggests, the Cboe Volatility Index ($VIX) is designed to reflect the degree of volatility that traders are expecting from the stock market over the short term. The methodology behind the index is worth a dig for volatility nerds, but in short, Cboe aggregates the weighted prices of S&P 500 Index ($SPX) call and put options across a sampling of strike prices.

The idea is to see what kind of price swings are being priced into broad-market options. When investors are bracing for big pops and drops, or rushing to hedge against a potential crash with puts, options premiums ramp higher. That increase in the implied volatility (IV) component of options pricing is then reflected by the absolute VIX reading - known as the “spot” VIX.

So if investors are expecting a smooth, easy bull market with no big surprises, the VIX might remain relatively low - say, around the 10-12 range. 

But if stocks are selling off, bond yields are spiking, blue-chip Dividend Kings are pulling their earnings guidance, and investors have no idea what kind of headline might rock Wall Street next? That’s when we’ll see VIX hitting levels in the 40s, 50s, and even higher.

What the VIX Tells Us About Sentiment

The nickname “fear index” might seem pretty self-explanatory here, but the VIX can be considered more accurately as a reading of investor uncertainty.

When the market is grinding slowly lower during the “acceptance” phase of a well-established bear market, it wouldn’t be unusual to see a relatively modest VIX reading corresponding with a steady downtrend.

On the other hand, the VIX can spike during periods of otherwise positive price action and in bull markets, particularly when elements of uncertainty are introduced that raise concerns about the potential impact on stocks - such as an unexpected election result.

Can You Trade the VIX Index?

The VIX itself is a statistic and cannot be traded directly, but there’s an entire volatility industrial complex of futures, options, and exchange-traded notes (ETNs) for those looking to speculate on volatility’s next directional move.

However, trading VIX derivatives is quite a bit more complicated than it may seem. For example, options traders who are accustomed to American-style equity options might be surprised to learn that VIX options are not only European-style - meaning they can be exercised only at expiration - but they also derive their value from VIX futures contracts at settlement, as opposed to spot VIX.

So when you buy a VIX call option, you don’t just need a big spike in the fear index - you need a big spike in the correct synthetic 30-day VIX futures contract at settlement… which is more or less the derivatives trading equivalent of actually tossing that oversized ping-pong ball into the tiny mouth of a tilted jug at the state fair.

And as for VIX ETNs that look to replicate or even leverage the fear index’s daily swings - these complicated assets should be approached with extreme caution only by experienced investors with high risk appetites, super-short holding periods, and - this is key - a willingness to read the prospectus.

How the VIX Affects Investors

We mentioned earlier that the VIX reflects how much implied volatility is being priced into short-term options. And that’s why a market crash is often the worst time to buy put options to bet on more downside - or even just to hedge your longs.

When the VIX spikes, put options (bets that an asset’s price will decline) get significantly more expensive as implied volatility increases. It’s almost like trying to buy insurance after your car is already wrapped around a tree; it’s too late to protect against the worst, and so now the premiums have soared.

That’s why the best time to manage portfolio risk with put options is during periods of relative calm. Learn more about managing volatility risk here.

The Bottom Line

High-drama headlines about the VIX aren’t going to improve anyone’s sentiment, but by understanding exactly what the “fear index” is measuring, how NOT to trade it, and how to properly manage your own portfolio risk, you’ll be able to keep your head up - even when all those around you are sending the VIX to new highs.

Elizabeth H. Volk, Barchart’s Senior Editorial Director, contributed to this report.