The Volatility Index (VIX) is a contrarian sentiment indicator that helps to determine when there is too much optimism or fear in the market. When sentiment reaches one extreme or the other, the market typically reverses course.
How it works:
The VIX is based on data collected by the CBOE, or Chicago Board Options Exchange. Each day the CBOE calculates a figure for a "synthetic option" based on prices paid for puts and calls. The computation of the VIX was changed in 2003 and is based on the S&P 500 option series.
The key question the Volatility Index answers is "What is the 'implied,' or expected, volatility of the synthetic option on which the index is based?" We already know the following variables:
-- The market price of the S&P 500
-- The prevailing interest rate
-- The number of days to expiration of the option series
-- The strike prices of those options contracts
What the equation solves is the "implied," or expected, volatility.
What is volatility? One definition describes volatility as "the rate and magnitude of changes in price." In simple English, volatility is how fast prices move. When the market is calm and moving in a trading range or even has a mild upside bias, volatility is typically low.
On these kinds of days, call option buying (a bet that the market will move higher) generally outnumbers put option buying (a bet that the market will go down). This kind of market typically reflects complacency, or a lack of fear.
Conversely, when the market sells off strongly, anxiety among investors tends to rise. Traders rush to buy puts, which in turn pushes the price of these options higher. This increased amount investors are willing to pay for put options shows up in higher readings on the VIX. High readings typically represent a fearful marketplace. Paradoxically, an oversold market that is filled with fear is apt to turn and head higher.
Source: InvestingAnswers.com
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