The VIX is kind of like a weather report.
Let’s talk about the Chicago Board Options Exchange Volatility Index -- luckily it’s also known as "the VIX".
"Basically it’s just a fancy name for what the market views in terms of risk, going forward,” says Eric Augustyn, head of options strategy group for Wells Fargo Private Bank.
So when markets are going down, the VIX is going up.
"The VIX, well I sometimes look at it a little bit as a temperature," says Augustyn.
That would be the temperature of fear. When things are uncertain -- like when U.S. credit was downgrading, the whole debt ceiling debacle, or when Russia was becoming a presence in Ukraine -- the VIX jumps. It’s a measurement of the price of calls and puts, a complicated way investors try to hedge their bets. This week, it’s around 13, but in 2008, during the financial crisis Augustyn notes "the VIX went from 14 to 80.”
So the VIX looks at the price of the insurance that investors are buying.
To understand why that matters just think back to the beginning of the Wizard of Oz when Dorothy's house, with her in it, gets picked up by a tornado and blown away. The VIX is like a weather report, and Chris Geczy, Academic director of the Wharton Wealth Management initiative and adjunct associate professor of finance at Wharton, says if Auntie Em or Uncle Henry had been able to check it, they might have known tornado season was coming up.
“If you think about the situation with Dorothy," says Geczy, "Dorothy really cares about insurance when the wind is blowing. And the VIX gives us a picture, and a forecast, for how the wind is going to blow.”
Remember, says Geczy, the VIX is forward looking. Most methods of measuring the markets use data from the past. So if Auntie Em and Uncle Henry had know the twister was coming they could have bought insurance on their house?
“That’s a possibility," says Geczy, though "they’d have to work very fast though, because the weather was coming in.”
Which means last minute insurance would be a lot more expensive. But Geczy says, if Dorothy had been watching the VIX, she would have known what the weather was going to do. And at least she would have had some options.