Just over a week ago, investors were shook from their bullish sleep. The major indexes inexplicably plunged lower as panicked investors scrambled to dump stocks.

The fear-gauge, or VIX index, spiked to 50 — a level not seen in nearly a decade — signaling extreme financial terror in the equity markets. Now, a week later, things have stabilized with the VIX retreating to the 18 zone. However, it is still 100% above its lows of this month.

The severe moves have refocused stock investors on this somewhat obscure index/indicator. Not since the financial crisis of 2008 have so many investors needed to understand what the VIX is all about.

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What Is The VIX?
The VIX, short for CBOE Volatility Index, was derived in 1993 by Professor Robert Whatley. Initially, the VIX was based on the OEX 100 index, but now it uses the S&P 500 as the base index.

The VIX is created via a weighted mix of prices for a variety of options on the S&P 500. The options are priced on the expected volatility or price change over the next month. Therefore, the VIX is designed to predict volatility over the next 30 days.

An excellent way to think about the VIX is as an insurance policy with the premium increasing as the risk level climbs. The higher the VIX climbs, the higher the number of options will be used to protect against the downside.

The number of the VIX represents the annualized expected percentage down move of the S&P 500 over the next 30 days.  More specifically, the VIX is calculated as the square root of the par variance swap rate for the next 30 days. The VIX traded as low as 9 and as high as 89 during the financial turmoil in 2008.

I know this all may seem exceedingly complicated. Imagining the VIX as the S&P 500 upside-down is an excellent way to visualize the VIX as inversely correlated with the S&P 500. As the VIX moves higher, the S&P 500 moves lower and vice versa.

The VIX has the moniker “the fear index” for a reason. The higher the fear of a plunge, the more traders hedge their positions with options, driving up the price of the options and, in turn, the cost of the VIX.

Now that we understand the VIX a little better, here are three things you need to know:

1. The VIX Does Not Trend
Unlike commodities and sometimes the stock market, the VIX does not exhibit trending behavior. It moves erratically, flatlines, then appears to spike randomly. A closer examination reveals a very choppy trading pattern in a tight range over the long term.

This non-trending type price behavior makes the VIX a complicated instrument to trade for all but the elite investor. The erratic behavior leads us to our next must know a thing about the VIX.

2. VIX Based ETN’s Are Exceedingly Risky
The current spiking and retreating action in the VIX have attracted many investors to exchange-traded notes (ETNs), like the iPath S&P 500 VIX Short-Term Futures ET (VXX), and options on the same.

Favorite stories like the celebrated option trader known by the moniker “50 Cent,” who banked $200 million during the spike, helped fuel the excitement around these volatile financial instruments. Most investors in these instruments don’t realize the other side of 50 Cent’s tale; it is believed that he experienced a drawdown around $200 million before his lucky win.

Posing even greater danger to investors are the leveraged VIX-based products like TVIX & UVXY. These hazardous investing vehicles compound the potential returns, often resulting in massive losses.

Think about it: The VIX itself is a derivative making the instruments traded on it, derivatives of a derivative. Then add leverage via options or the leveraged ETFs, and it creates a very chaotic and dangerous tool.

Unless you are willing to lose your investment, avoid directly trading the VIX. If this is the case, what good is the VIX? This leads us to the next thing you need to know.

3. One Way Professional Investors Use The VIX
The VIX can be a powerful tool to help forecast the future direction of the stock market. Make no mistake, it is far from 100% accurate. But when used the right way, the VIX can add tremendous insight to your market direction projections.

The VIX can easily be used to help set your market bias. If the VIX is trading below its 20-day simple moving average, it is a good bet to stay out of the market as it may be setting up to return to the norm. If the VIX is trading above its 20-day simple moving average, look for long positions as it is likely the VIX will snap back to its average price, meaning stocks should move higher.

Risks To Consider: All market projection techniques have flaws. Only use the VIX as a tool to help clarify what may happen in the future, don’t base your decision strictly on VIX price movements.

Action To Take: Start watching the daily VIX chart with a 20-day simple moving average. Avoid trading VIX products directly; they are simply too risky!

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