Have you heard of the Cboe volatility index (VIX)?

Investing in index funds through Exchange Traded Funds (ETF’s) is becoming more and more popular. I would even say that there is a good chance you already invest in the S&P500 or other popular indexes. Those ETF’s are a great way to invest in stocks almost passively while paying low fees. However, while it can be a good strategy to passively invest and forget, it is wise to keep an eye on what the market is doing so you can make informed decisions.

The VIX (Cboe volatility index) is an index created by the Chicago Board Options Exchange (Cboe) that measures the stock market’s expectation of volatility (price swings and therefore risk) based on the S&P500. Using different volatility calculation methods, it generates a 30-day projection. This index is also referred to as the fear index or fear gauge. This means that the VIX index represents the degree of fear amongst market investors.

If you track the value of the S&P500 and the VIX you will see that there is a negative correlation between volatility and the stock market returns. Because the S&P500 represents such a significant portion of the stock market, when the S&P500 is high it generally means that the stock market is less volatile and investors are less fearful, so the VIX will be low. When the S&P500 is low it generally means that investors are more fearful and the stock market is more volatile, so the VIX will be high.

VIX is not the only index that measures volatility. Other indexes generate projections based on different timeframes. Some of these indexes include the Cboe ShortTerm Volatility Index (VXSTSM), the Cboe S&P 500 3-Month Volatility Index (VXVSM) and the Cboe S&P 500 6-Month Volatility Index (VXMTSM).

Interestingly, you can take a position in VIX through VIX-based Exchange Traded Products such as the ProShares VIX Short-Term Futures ETF, the iPath Series B S&P 500 VIX Short Term Futures ETN (VXXB) and others. This means that you can diversify your portfolio by investing in volatility. Remember, generally when the stock market is down, volatility is up, and vice versa.

While VIX-based ETF’s can be an interesting way to diversify your portfolio, it is important to be careful when investing in volatility. These investments are usually meant to be short-term, and might not offer great returns in the long term. I would not suggest allocating a large portion of your portfolio to this asset class. But even if you do not intend to invest in those funds you can still gain valuable information from the VIX and use it to get a better picture of what the stock market is doing and what to expect of your investments.

Have you considered investing in a VIX-based ETF? Let me know your thoughts in the comments.