Simply put, it measures investors' expectations for big prices swings.
Over time, the VIX has become known as the "fear index" or "fear gauge." When the VIX is high, fear is thought to be high. And when it's low, complacency is thought to be high.
Traditionally, fear and complacency are contrarian indicators, which help traders and investors predict short-term moves in the market.
Unfortunately, the the empirical evidence on this is anything but clear.
"Looking back at volatility data reveals that there are much higher probabilities for market gains when the VIX is sitting between 10 and 15 than when it is in the 20-25 range," wrote Citi's Tobias Levkovich in his August chartbook. "Levels of 20-25 do not generate good probabilities of market gains."
Levkovich reviewed the short-term returns in the S&P 500 given various levels in the VIX since 1990.
At the low 10-15 range, the 3-month, 6-month, and 12-month returns were positive 74.4%, 85.0%, and 87.9% of the time, respectively.
At the low 20-25 range, the 3-month, 6-month, and 12-month returns were positive 58.0%, 55.8%, and 60.5% of the time, respectively.
"Hence, the so-called "fear gauge" is wildly misunderstood and misinterpreted by many equity observers," he added.
So, while the VIX may reflect expected volatility, it does a poor job of predicting actual volatility.
Levkovich currently sees the S&P 500 falling to 1,615 by the end of the year. It's worth noting that this was a target he established last September. And he entered 2013 as the most bullish strategist on the Street.
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