The VIX is a contra-indicator of market health, rising when stocks are dropping and going down when stocks are recovering. The VIX is a predictive indicator of market volatility in the short term. When explaining the VIX indicator to someone with little day-to-day knowledge of the financial world, it's important to make the connection between investor behavior and stock prices. Once all elements that affect the VIX are outlined, making investment decisions based on it becomes easier.
1. State that the S&P 500 is the core index for U.S. equities. The S&P 500 covers 75 percent of the total stock market and its worth is a strong indicator of the health of the stock market as a whole. Tracking the upward and downward trends of the S&P 500 prices is a way to track the potential rise and fall of stocks.
2. Explain that the VIX is the Chicago Board Options Exchange Volatility Index, which monitors S&P 500 activity. The VIX projects volatility of the S&P 500, and therefore the market as a whole, for a 30-day period. The VIX is sometimes called the "fear gauge" because it reflects the mood of the market and its investors.
3. Elaborate that if more investors are buying put than call options, they are collectively betting the market will decline. If this is the case, the VIX rises. If investors are doing the opposite, buying more call than put options, they are betting the market will rise. In this latter case, the VIX falls.
4. Note that conventional wisdom would have the investor buy into the market when the VIX is high. A high VIX is an indicator of a fearful market where investors are selling. If investors are selling, stock prices are falling. As a result, investors who choose to buck the trend and buy into the market can get quality stock at cheap prices and make a profit by selling the stock when it rises.
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