A lesson on Wall Street's 'fear index'

A lesson on Wall Street's 'fear index'

Specialist Justin Bohan holds his head as he works at his post on the floor of the New York Stock Exchange, Thursday Oct. 9, 2008.

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Story Published: Oct 10, 2008 at 6:39 PM PDT

Story Updated: Nov 21, 2008 at 3:43 AM PDT

By Matt Markovich

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Instead of watching the Dow Jones Industrial average or the NASDAQ average take a plunge, maybe you should be watching the "VIX" for an indicator on when this market will hit bottom. Traders and financial wizards watch the VIX as a measure of the fear in the market. That's why it's often called the "fear index."

So what is the VIX anyway? In very simple terms, the VIX is a ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index. It measures the market's expectations of the stock market's volatility over the next 30 days. It's really a mathematical equation based on options on the S&P 500.

To make it as simple to understand as possible, options are what a trader thinks the price of a stock will do in 30 days, either go up or go down. The more traders disagree on the future price of a stock, the more there's volatility. The more jollity, the higher the VIX and the more uncertainty there is in the market, therefore fear is actually translated into a number.

The VIX was introduced in 1993 by the Chicago Board Options Exchange. But in 2003 the methodology changed. This week, the VIX hit its highest lever every since 2003, but analysts say the older methodology showed that the fear in the 1987 crash was higher.

The VIX has become a real indicator for the average investor to gauge the uncertainty in the market. Still, expert investors say the VIX should be used a tool for investing and should not be watched too closely, just as it's unhealthy to watch the Dow or NASDAQ averages every moment of every day.

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