Most investors think of the VIX Indicator (VIX) as the "fear gauge."
True to form, the old saying with the VIX is, "When the VIX is high, it's time to buy."
But experts look at the VIX as much more than just an index.
They view the VIX as possibly one of the best contrarian indicators in the business.
While most investors are scrambling to figure out whether the market's headed up or down, savvy pros use the VIX both as means of protection and a source of profit.
"It gives you an idea of how uneasy people are about the markets," Joe Levin, vice president of product development at the Chicago Board of Options Exchange (CBOE) told CNNMoney.
That is, it tells you whether or not the markets have reached an extreme level of sentiment - either bullish or bearish.
More often than not, it is the action in the VIX that signals major market tops and bottoms.
But before we get into how to use the VIX, we need to understand what the VIX actually is.
What the VIX Indicator Measures
Contrary to what most people think, the VIX doesn't measure actual stock market volatility.
Instead, it tracks the trading in options on the S&P 500 to indicate how investors expect the market to move over the next 30 days.
In this case, as investors buy more put options, they get more expensive and the VIX goes higher. Conversely, the reverse is also true: when investors sell options, they become cheaper and the VIX begins to fall.
The VIX then, is really a reflection of the price of calls and puts on the S&P 500.
It is quoted in percentage points and roughly translates to the expected annualized movement in the S&P 500 over the next 30 days.
For example, a VIX reading of 15 implies the S&P could swing higher or lower by 15% over the next 12 months, or about 4.33% over the next 30 days.
As a contrarian indicator, the VIX usually has an inverse relationship with the markets. When the market is rallying the VIX tends to drop; when the market is tanking the VIX tends to rise.
The scarier the broad market decline the higher the VIX tends to go - hence its reputation as the "fear gauge." In fact, during the worst part of the 2008/2009 bear market the VIX soared as high as 80.
In today's markets, however, a VIX reading greater than 30 is generally associated with a large amount of volatility and uncertainty, while values below 20 generally reflect less stressful times.
Protecting Profits with the VIX
While such volatility is scary, there is a way to protect yourself, and even profit from it.
When the VIX fell as low as 16.6 on July 6 last year, Money Morning Capital Wave Strategist Shah Gilani warned investors to protect themselves against potential volatility.
"The low VIX creates an excellent opportunity for you to buy put protection at reasonable prices," Gilani said."In the face of future unknowns, and as long as implied volatility is low, you should take advantage of cheap puts to add some portfolio protection ... just in case.
Exactly two days later the VIX began a relentless climb. Investors who heeded his advice were glad they did.
The VIX jumped to 48 and remained above 40 throughout October as the S&P 500 tumbled to a yearly low of around 1100.
Meanwhile, Gilani had also advised his Capital Wave Forecast subscribers to hedge with put options in May and June.
On Aug. 8- the day the Dow Jones Industrial Average plunged 635 points - subscribers to Capital Wave Forecast locked in gains of 456%, 455%, 371%, and 197% on four of those holdings.
Should You Trade the VIX?
Investors who want to trade the VIX should keep in mind that VIX-linked products are short-term trading tools for active traders who know the risks.
But if you believe that market volatility will surge again, you can buy VIX call options (the right to buy) or puts (the right to sell).
Another approach would be to trade VIX futures based exchange-traded notes (ETN) and exchange-traded funds (ETF), including the iPath S&P 500 VIX Short-Term Futures ETN (NYSE:VXX) and S&P 500 VIX Mid-Term Futures ETN (NYSE:VXZ).
Because they are cheap to own and trade, they make for a fairly good, simple alternative for investors looking to hedge their risks and protect their profits.
But you don't have to trade the VIX directly to make money on it. Most often, the movements in the VIX are inversely correlated to the S&P 500 and the market in general.
That means trading S&P 500-based products with plenty of liquidity.
When the VIX is high you can buy the S&P 500 SPDR (NYSE: SPY), including futures and options.
Of course, it never hurts to have the help of an experienced Wall Street professional.
Earlier this week, Shah told his Spin Trader subscribers exactly how to use the VIX to position themselves for a correction - much like he did last summer.
To learn more about Spin Trader, click here.
In the meantime, keep your eye on the VIX. It's one of the best contrarian indicators in the markets.
News & Related Story Links:
- Wall Street Insights & Indictments:
A Flash Crash, Fat Fingers, and Positioning for a Crash
- Money Morning:
The Stock Market Volatility Index: What the VIX is Telling Investors
How to make money on volatility