The VIX is a unit of information within the financial market system that investment professionals use to make investment decisions. There are derivatives (options and futures) of that unit of information that investment professionals (and regular people) can use as tools to trade and/or invest within the financial market ecosystem.
What unit of information does the VIX track? the volatility1 of the S&P 500 index over the next 30 days, annualized. What does this mean?
Volatility is a measure of the severity of the return of an asset, regardless of whether the return is positive of negative. Lets say that on Monday Apple stock goes down 6%, Tuesday up 5%, Wednesday down 7%, Thursday up 8%, and Friday down 10%. Since Apple stock typically moves under 2% per day, we can infer that this week Apple stock was volatile. The higher the volatility of an asset, the riskier it is perceived.
The S&P 500 index is a stock market index composed of the 500 largest American companies that trade in public exchanges. It is probably the most common financial market index today.
So what the VIX tracks is what market participants are implying the S&P 500 Index volatility will be over the next 30 days. The VIX presents that number in percentage terms, which is then annualized. The higher the VIX percentage, the higher it is implied that the risk of the S&P 500 index is over the next 30 days. This is why the VIX is considered the fear gauge. It informs market participants how risky it is to invest in the S&P 500 index in the near term.
How market participants derive future implied volatility of the index and how the Chicago Board Options Exchange (The creators of the VIX) calculate the VIX is somewhat complex and beyond the scope of this post. You can read the VIX whitepaper here. I would suggest also looking at The Black-Scholes Model formula for pricing options before looking at the whitepaper. I am happy to discuss in more detail the complexity of the VIX and options pricing in private.
This is not investment advice. For informational purposes only. I hold a long position on the VIX through call options.
1 To be more specific, the VIX tracks the variance, or volatility squared. Non quantitative financial professionals use variance and volatility interchangeably, creating a bit of a confusion.