A Beginner's Guide to the VIX: The Market's Fear Gauge

What is the VIX?

The CBOE Volatility Index, or VIX, is a tool that tells you how nervous Wall Street is feeling. Investors often call it the market’s "fear gauge."

Instead of tracking whether stock prices are going up or down today, the VIX measures how much volatility in stock prices investors expect to see over the next 30 days. It figures this out by looking at the prices people are paying for insurance on the S&P 500.  In the stock market, this 'insurance' takes the form of options contracts, which are financial agreements that give investors the right to sell their stocks at a locked-in price if the market crashes.

How the VIX Moves with the Stock Market

The VIX and the stock market generally move in opposite directions, acting like a financial seesaw:

• When the stock market is calm and rising: Investors feel safe. They buy less financial insurance, and the VIX goes down.
• When the stock market drops: Investors panic and rush to buy insurance to protect their portfolios. This sudden demand causes the VIX to spike upward.

VIX Trading Rule

When it comes to trading individual stocks, my mentors told me to stop buying stocks when the VIX climbs above 18 and reduce risk (trim positions) when it passes 20. Here is why this rule makes sense:

• VIX below 15 (Green Light): The market is calm, predictable, and generally safe for buying healthy stocks.
• VIX above 18 (Yellow Light): Trouble is brewing. Price swings are getting larger, meaning the risk of losing money on a new investment is rising.
• VIX above 20 (Red Light): The market is officially in a high-fear state. During these times, stock prices can drop violently and unpredictably.

Buying stocks when the VIX is over 20 is like trying to catch a falling knife. By waiting for the VIX to cool down below these numbers, you protect your hard-earned cash so you can buy stocks when the market is stable again.