The CBOE Volatility Index, also known as the “VIX”, is often referred to as the market’s “fear indicator”.
The Chicago Board Options Exchange shows the movement in the price of an option on a diversified set of stocks. Generally, market participants will hedge, or bet against the market, using options. If more options are being purchased, it most likely means the price will rise and that signals that more investors are looking to hedge. The VIX thn, is a way to measure how worried investors are about the market.
What are the limitations to the VIX index?
Any indicator is only as good as the data you feed through it.
Traders buy and sell options on the VIX all the time. The CBOE takes the average of the difference between the buying and selling price across a number of different options.
It would be a mistake to think that the VIX tells you anything about where the stock market is headed. Being a function of prices, the index itself should not have much predictive power on equity prices.
It actually measures expected volatility, because options are contracts with stipulations on actions that take place in the future.
“Why the VIX went haywire—and how it got fixed”, http://www.cnbc.com/id/102274049#.
The Misuse of the Stock Market’s “Fear Index”, http://online.barrons.com/articles/SB50001424052748703464104576616983309689062.