What is the Volatility Index and Why Should I Care?

Less than a couple months into the year and traders are already buzzing about the high volatility in the forex market. In fact, some market experts are predicting that volatility this February might be higher compared to that of January! What in the world are they fussing about?

What does volatility mean?

First up, let’s take a few moments to understand what volatility is all about. Technically speaking, volatility measures the standard deviation of historical market prices. Financial mumbo-jumbo aside, volatility simply refers to how much price action fluctuates over time.

Some of my trading buds compare market volatility to a girl’s mood swings, which are often associated with varying degrees of sensitivity. In a highly volatile market environment, the reaction to positive or negative news is typically magnified, much like a girl who tends to make a big deal out of small issues when she is in a sensitive mood.

How is market volatility measured?

Unlike a girl’s mood swings which come and go without much warning, market volatility can be measured based on past price action. In particular, market watchers like to look at the Volatility Index or VIX to gauge how volatile price action could be in the future.

The VIX keeps track of the implied volatility of S&P500 options and is used to predict market volatility for the next 30 days. Seasoned traders believe that periods of high volatility tend to get clustered, which suggests that rising VIX levels signal that higher market volatility is to be expected.

The VIX is also dubbed as the “fear index” because rising VIX levels reflect market uncertainty while falling VIX levels indicate improving market confidence.

How is the VIX looking these days?

To understand whether the VIX is at a high or low point, it helps to compare it to its average levels. For the past couple of decades, the median stands at 18.5, which simply means that half of the VIX readings came in above 18.5 while the other half printed below 18.5.

Thanks to last week’s jumpy price action, the VIX is currently hovering around 21.44 – its highest level since December 2012 when U.S. fiscal cliff concerns dominated the headlines. This also marks the first time that the VIX landed above the 20.0 level in the past four months!

What the heck am I supposed to do now?!

Calm down! To put things in perspective, the VIX is still miles away from the 60.0 levels reached during the 2008 financial crisis so there’s no reason to panic just yet. Analysts say that the sudden pick-up in volatility may have been caused by investors scrambling to hedge their positions against a potential market decline.

With all the talk of a possible emerging markets crisis, it’s no surprise that several market players are bracing for the worst. However, one of the worst ways to deal with higher levels of market anxiety is to be increasingly anxious with your trading decisions as well. Remember that we are dealing with a potential shift in market environment so it’s crucial to maintain a focused mindset and keep your emotions in check.