Volatility index surges in the troubled stock market

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Volatility is back in the stock market with a vengeance.

By one closely watched measure, volatility expectations jumped a whopping 50% Monday as stocks were pounded mercilessly for the second time in the last three trading days.

As the Dow Jones industrial average sank nearly 635 points, the VIX index, also known as the fear gauge, jumped to its highest level since early 2009.

The index (charted below) gauges investors’ expectations of short-term market volatility based on their trading of S&P 500 index ‘put’ and ‘call’ options, which can be used to hedge against market swings.

The gauge typically spikes during turbulent periods when stocks are getting pummeled.

Other than a brief rise in March after the Japanese earthquake, volatility had been relatively subdued this year. It began climbing about two weeks ago and took a big jump Thursday before its even larger leap Monday.

Some traders consider the VIX a useful contrarian indicator that can signal a coming turn in the market.

When petrified investors dump stocks en masse, they set the stage for a rally in which savvy investors can pick up bargains.

For example, the mid-March peak in the VIX following the Japanese earthquake coincided with a trough in the Standard & Poor’s 500 index.

But a surge in the VIX isn’t always a good time to jump in.

The fear gauge hit an all-time peak during the global financial crisis in November 2008. But buying stocks then would have led to more losses. The market didn’t bottom out until the following March.

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-- Walter Hamilton