A key indicator for understanding market sentiment

In the world of finance there are indices that measure performance, others that anticipate economic trends, and still others that reveal investor sentiment. The VIX, also known as the “fear index”, belongs precisely to this last category. It is a useful instrument for understanding how much nervousness — or confidence — pervades equity markets.

Let us examine what it is, how it works, and why it matters to investors.

What Is the VIX?

The VIX (Volatility Index) is an index created by the CBOE (Chicago Board Options Exchange) in 1993 to measure the implied volatility expected over the next 30 days of the American equity index S&P 500.
In simple terms, the VIX tells us how much the market expects the S&P 500 to fluctuate — upwards or downwards — in the short term. It does not measure past movements, but future expectations, calculated by observing the prices of options on that index.

Why Is It Called the “Fear Index”?

The nickname “fear index” stems from the VIX’s behaviour during periods of crisis:
when investors are concerned, they purchase more options to protect their portfolios. This drives up the prices of options — and, consequently, the value of the VIX.
Conversely, during periods of stability, demand for hedging falls and the VIX tends to decline.
Historical examples:

  • In 2008, during the collapse of Lehman Brothers, the VIX surpassed 80.
  • In March 2020, with the outbreak of the Covid-19 pandemic, the VIX returned to comparable levels.
  • During periods of relative calm, the VIX typically remains between 12 and 25.

What Does the VIX Actually Measure?

The VIX does not predict whether markets will rise or fall. It simply measures the magnitude of the expected movement, that is, how much market participants believe the S&P 500 may move (in either direction).
A low VIX indicates a “relaxed” market, but not necessarily one destined to rise.
A high VIX signals “tension”, but does not guarantee an imminent downturn.

How Is It Calculated?

The VIX is based on the prices of OTM (out-of-the-money) options on the S&P 500 with maturities between 23 and 37 days. The CBOE uses a mathematical formula that accounts for the implied volatility of a range of options, weighting them appropriately.

Implied volatility = how much market participants “pay” to hedge against future movements → the higher the price of options, the greater the expected volatility.
Since 2003, the calculation methodology has been updated to reflect more precisely the entire curve of available options.

What the VIX Tells Us (and What It Does Not)

It tells us:

  • The level of perceived uncertainty among market participants.
  • Whether sentiment is oriented towards stability or nervousness.
  • How turbulent the coming weeks might be.

It does not tell us:

  • Whether markets will rise or fall.
  • What the cause of the uncertainty is (macroeconomic context is required).
  • Whether the perceived risk is well-founded or the product of emotional excess.

How Can It Be Useful to an Investor?

Understanding and monitoring the VIX can be useful for:

  • Gauging the emotional context of the market and avoiding being swept along by news flow.
  • Evaluating the timing of certain decisions, such as gradually entering or exiting equity investments.
  • Considering hedging or diversification strategies during periods of high volatility.
  • Interpreting volatility correctly as a normal component of the market, not merely as a threat.

A word of caution: it is not possible to invest directly in the VIX. However, derivative financial instruments exist that replicate it (such as VIX futures or volatility-linked ETFs/ETNs). These are complex instruments and are suited only to highly sophisticated investors.

Bonus: VIX and Realised Volatility

An important clarification: the VIX measures expected volatility, not that which is actually realised. The two can sometimes diverge significantly. For this reason, the VIX should be interpreted as a thermometer of investor sentiment, rather than as a “prophecy”.

Conclusion

The VIX is one of the most useful instruments for those who wish to interpret markets in an informed manner. It does not tell us what will happen, but it tells us how much the markets fear that something might.

Understanding it and knowing how to read it enables the investor to avoid being conditioned by collective emotion, and to build more balanced strategies over time.