What is the Volatility Index and Why is it so High Right Now?

The Volatility Index, widely known as the VIX, is an index used as a measurement of the market's expectations of volatility in the next 30 days. The Chicago Board of Exchange setup the Volatility Index so that investors would have a way literally quantifying the the concept of volatility in the marketplace. In order to better understand the volatility index though, you must first understand what volatility means. Volatility itself is defined as the tendency to fluctuate sharply and regularly. By understanding that volatility itself means sharp fluctuations we can better understand that a lower reading on the VIX tends to correspond with a period of low amounts of fear and nervousness, while a high reading on the VIX generally means there is a great amount of fear and worry in the marketplace. The VIX is calculated by a wide range of in the money and out of the money call options and put options. The options markets and their traders drive the price of the VIX. As recently as 2004 VIX futures trading was allowed, and then in 2006 VIX options were launched. The basic idea of the VIX index is to understand that a high reading in the VIX typically means that investors are very fearful and uneasy about their investments, while a low level can mean that they are very comfortable and sometimes even complacent.

What is seen as the normal levels for the Volatility Index? Most traders associate a level above 30 with fear and unease in the marketplace, and a level below 20 one of complacency and complete calm.

How is this index used as a contrarian indicator by many? Many traders watch the VIX very closely because in the past it has shown to predict quite well market bottoms and market tops. When the VIX spikes to extremely high levels it has typically meant that the market is sliding very quickly and a bottom is quite near. When the VIX goes to very low levels it generally means the bull market has just about run its course.

Recently the Volatility Index has spiked to its highest level ever. This is absolutely a sign of the amount of fear and nervousness there is around the market right now. The fear of the financial crisis and the housing crisis has spread and now the fear of a deep recession or even a depression has driven the VIX to an unheard of level, above 80. Many in the market are now having a hot debate as to whether this amazingly high reading in the VIX is indicative of a bottom nearby, or simply a sign of how horrible the times are.

Obviously the VIX has never been in place during any other major economic crisis so this is more of a wait and see period than anything else for most technicians. It's possible that the VIX could sustain very high levels if a deep recession or depression take shape, but it's also possible that it could mean the stock market is due to bottom soon. Keep a close eye on the VIX in the coming months and see which turns out to be the case.