The VIX Index is like a crystal ball to some investors. Photo: Pixabay.

Wouldn't investing in the stock market be easier -- and a lot more lucrative -- if, before we invested, we knew what the market was going to do in the coming months? That seems a laughable proposition, yet there is an indicator out there that many people look at for clues about the market's upcoming performance: the VIX index.

Nuts and bolts
So what is this VIX index, exactly? Well, its full name is the Chicago Board Options Exchange Volatility Index (VOLATILITYINDICES:^VIX). It aims to gauge stock market investors' anxiety by aggregating current prices for put and call options for the S&P 500 Index, running them through some calculations, and producing an educated guess about how much the index is likely to move over the coming 30 days. The VIX reading itself is adjusted so that it reflects expected volatility over the coming year. The VIX level rises when put options get more active and falls when investors are buying more call options. (A put option gives one the right to sell a certain security at a certain price within a certain limited time frame, while a call option gives one the right to buy.)

How do you make sense of the VIX index? Well, the higher it is, the more expected volatility it reflects, and vice versa. Think in terms of percentages. If the VIX is at 15, that reflects an expected volatility level of 15%, with the S&P 500 having a 67% chance to move higher or lower than its current level by up to 15% over the next year. (The 67% confidence level reflects one standard deviation, a statistical measure.) A VIX reading of 20 or lower is generally considered to reflect low volatility in the market, while readings of 30 and above are considered rather volatile.

The VIX soared during the 2008-2009 financial crisis. Image: WalkingGeek, Flickr.

Who's it for?
Investors looking to build wealth over the long haul don't need to pay much attention to the VIX index, as it's focused on the short term only and is therefore of questionable use.

Market sentiments are always changing, so the VIX's reading of the coming year's volatility can change considerably from week to week -- especially when there is a major event, such as a market crash, big economic news (such as stalling growth in China), political upheaval, and so on. Remember that the VIX isn't based on actual volatility, but rather human sentiment and expectations.

Despite that, the VIX has tracked the overall market's movements rather closely, though far from perfectly. The CBOE notes that between 2000 and 2012, the VIX was bullish about 82% of the time when the S&P 500 rose and bearish about 78% of the time when it dropped.

Overall, for most investors, the VIX Index can serve as food for thought, or can be disregarded entirely. Still, it's good to understand what it is and what it means.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.