I’ve gotten a lot of questions about what happened with the markets the week of February 5. Many of the questions are on volatility and “the VIX.” Explaining an event caused by many complicated tools can prove very difficult, especially when most investors have no background. In this series, I’m going to escort you step by step to some answers. I’ll start with the background information you’ll need. Skipping to the punchline won’t be of much use if you can’t speak the language. I’ll explain the factors that set the stage for the volatility. I’ll attempt to explain what happened. Finally, I’ll suggest some means of dealing with it.

What is “the VIX”?

“VIX” is the ticker symbol for the Volatility Index maintained by the Chicago Board of Options Exchange (CBOE). Volatility relates to risk, or the expectation of risk. Risk breeds fear. The VIX index measures what market participants expect volatility to be over the next 30 days in the S&P 500. In doing so, it has earned the reputation of being an indicator of investor sentiment. Thus, entertainers from the financial news media have given it nicknames such as “the fear index” or “the investor fear gauge.” How is the price level of the VIX decided? We “vote” on it, but not in the way you might assume. The “votes” come from the price of options.

Options are securities whose price is derived from the price of other investments, e.g., stocks, indexes. I won’t get into the math behind it, but the VIX is based on the price of options. It’s helpful to think of options as insurance contracts on said other investments. The more certain you are that an adverse event will happen, the more likely you will be to want to buy insurance. This is true in all areas of life, but you aren’t the only one who has to make a decision. The seller of the insurance also has to make a decision before he sells you insurance. He needs to believe he can sell enough insurance premiums to cover the costs of insurance claims. He knows he’s going to have some losses, but he needs to have more gains than losses to stay in business. If he believes there is a greater risk of more or greater claims, he’ll charge more for insurance. The less certain he is, the more of a premium he’ll demand. The more people who want to buy insurance, the more he’ll be able to demand for it.

There are lots of factors that influence the price of insurance. All factors reduce to the free-market mechanism by which buyers and sellers “vote” on what the price should be. People who demand insurance and people willing to supply insurance have to come to an agreement. If the VIX is rising, then demand for insurance is going up. The VIX tries to measure how expensive insurance is and how volatile the market expects its price to be. When you understand that the VIX is a “demand for insurance” gauge, it becomes clear why it is interpreted as an indicator of how fearful investors are.

It’s important to understand that this is not a guarantee of volatility. It’s what we can deduce the market as a whole expects volatility to be. We base that expectation on what we can see from how much the market is paying for insurance. In other words, the VIX measures where the market expects volatility to be in the future by looking at how much volatility options are implying with their price changes. Many people talk about the VIX in the context of the stock market, but have no idea they are talking about options prices. There is a feedback loop by which the stock market and the VIX can influence each other. Still, it’s important to note that the VIX is always forward-looking and is not derived from the price of stocks. People often note that the VIX is very high when the market is going down fast. Yet, it’s not completely accurate to say that the VIX went up because the market went down. The devil is in the details. The VIX goes up because investors expect that a recent pullback in the market might continue. In other words, recent events in the market influence the VIX. What’s happening in the market today influences how people think the market will behave over the next 30 days. So, the VIX could go up before the market drops because investors expect it to go up. Likewise, the market could surprise the VIX by going down, causing the VIX to jump after the market falls.

Sound complicated?

That’s unavoidable, because the VIX and the stock markets intertwine. A stock investor can’t avoid the VIX any more than a Texas cattle rancher can completely avoid manure. We can step around it as much as possible, but since it’s a part of the business we’re in, we’re better off finding a use for it!

I won’t go into all the ways the VIX is important in this piece, but understand that analysts who never intend to trade an option often keep a close eye on it. The VIX isn’t just for options traders, though options traders tend to have a greater comfort with it. Market-related and market-derived investments are all related and they all influence each other. So there is no way to say, “I don’t want anything to do with the VIX,” unless you get out of all equity investments. Choosing not to trade or invest in the VIX doesn’t mean the VIX can’t impact you. Thus, it’s important to work with an advisor who has a thorough understanding of it. Further, there are many ways to trade options and futures, and many uses for them. There are ways that add diversification benefits, reduce the risk of a portfolio or even “hedge” the portfolio against some degree of losses. Yet there are ways to trade that are aggressive and even speculative. In essence, options and futures are a lot like cars. The characteristics of the driver are often even more important than the car itself!

In part two, I’ll talk about a few reasons why the VIX becoming a trading tool is important to all investors.