NEW YORK (MainStreet) After months of calmness, volatility in the markets jumped higher this week, leaving some investors on edge over a potential sell-off.
The Chicago Board of Options Exchange Volatility Index, or VIX, known as Wall Street's fear gauge, uses the options market to track volatility over the next month. On Wednesday, the VIX ended the trading day at 11.65, but opened at 13.08 on Thursday morning, a 12.3% jump, before settling to its Thursday close of 12.59.
The VIX spikes when investors are worried about the markets. They buy options to cover their downside amid potential losses in the broad S&P 500, pushing the VIX up.
Where the VIX stands now is well below its historical average in the low 20s, and significantly lower than its October 24, 2008 peak of 89.53, during one of the worst months in financial history.
Still, the markets have been on an impressive ride, leaving analysts wondering how much more fuel is remaining in the tank. In 2013, the S&P 500 gained a staggering 32%, including dividends, and is up 6.3% so far this year. The markets are long overdue for a correction, defined as a 10% drop in a major stock market index, which was last seen in August 2011 during the European debt crisis and the credit rating downgrade in the United States.
The recent uptick in the VIX is prompting investors to wonder if a correction is now on the horizon.
To dig deeper, investors also use realized volatility, which gauges how the market has moved in the past. Sometimes, the best indicator of how the market will move in the future is how it has moved previously.
"Realized volatility stands at an annualized 7.5% and with the VIX significantly higher at 12.6, the VIX is telling me I should be a lot more worried," says Tim Edwards, director of index investment strategy at S&P Dow Jones Indices. "That's not necessarily a massive alarm bell."
Edwards reminds us that the VIX is a summation of all market fears, including ones known as tail events, such as earthquakes, which have a low probability of coming to fruition, but would still cause a major shock to the markets should they occur.
"It's likely that tail events aren't reflected in the markets, but you would expect it to be reflected in the VIX," he says.
Keep in mind, the VIX tracks market swings. Just because the VIX rises, doesn't mean the market is going to drop, but Edwards says history shows us that big movements tend to indicate falling markets, not rising ones.
"The VIX isn't signaling a high degree of concern right now," Edwards tells MainStreet. "It's slightly more worried than usual, but that doesn't mean investors don't need to be worried."
Written by Scott Gamm for MainStreet. Gamm is author of MORE MONEY, PLEASE.