


The Chicago Board Options Exchange's volatility index, or VIX, is a gauge of investor sentiment. But its predictive power is limited to tallies of trades that have been made in the past. "The VIX is an important tool," says Ben Londergan, co-chief executive of Group One Trading. "But it's not the be-all and end-all factor to time your entrances and exits to the market."

The index, launched in 1993 with data stretching back to 1990, moves up and down depending on the price that investors are paying for options on the Standard & Poor's 500-stock index. When investors buy bearish options on the S&P, known as puts, the options become more expensive and the VIX moves higher. Conversely, when investors sell those put options on the S&P, the options become less expensive and the VIX moves lower.

Traders' Expectations

The options activity reflects traders' expectations of market conditions three or six months into the future. But a trader's outlook can change at a moment's notice. (Consider Sept. 11, 2001, for example.) For that reason, a recent study from research firm Biryini Associates concluded that the VIX's predictive powers are quite limited.

If anything, the VIX is most useful as a contrarian indicator. When the index remains unusually high or low for an extended period of time, it can mean a major market change is in the offing. For instance, the VIX had trended downward, and stocks upward, for several years leading up to the Dow Jones Industrial Average's record close on Oct. 9, 2007. Then the subprime meltdown sent stocks plummeting as a historic bear market took hold.

One year later, during the diciest moments of the financial crisis, the VIX spiked to a record high of 80, capping a yearlong rise. Then it reversed course and fell sharply as stock markets enjoyed their most dramatic rally in decades.

Right now the VIX isn't pointing to a major market move, since it is just now settling into its historical range. Under normal circumstances, the index moves in a fairly narrow band, mostly between 10 and 20. Having drifted gently downward for months, the index now sits at 17.

The recent drop is partly the result of an unusually steady stock market rally: In eight consecutive sessions over the past two weeks, stocks gained a total of just 2.2%, an amount that could easily be erased in one trading session.

Using the VIX

So how can traders best make use of this oft-misunderstood index? By studying what is happening in the futures market. Professional investors have traded futures contracts on the VIX since 2004. When the futures are significantly different from the VIX itself, it is a signal that the index—and possibly the stock market—could soon reverse course. When the futures are significantly lower, it could be a bullish signal. When they are markedly higher, it could be bearish.

The latter is the case now. As of Friday's close, the July futures on the VIX were trading at 23.25 and August futures at 23.40, considerably higher than the VIX's 17. That suggests the pros are bracing for more volatility as the year wears on. If they turn out to be right, that could bode poorly for stocks.

"There's a pretty big discrepancy [between the VIX and the futures]," says Brian Overby, an options analyst at the brokerage firm TradeKing. "So even though there's a lot of complacency right now, it looks like the marketplace is expecting things to get a lot more volatile."

—Brett Arends contributed to this article.

Write to Tennille Tracy at