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Understanding the VIX

By  +Follow October 14, 2013 8:46AM
Tickers Mentioned:

Traders have long been able to find ways to create mathematical formulas to track certain types of market movement so that they can then place bets on them. Between the hundreds of different indices and ETFs out there, if you have a prediction about just about anything that might happen throughout the global economy, there’s a way to profit (or NOT profit) from your inkling.

And one of the most popular things they’ve ever created was the formula that’s now used for the Chicago Board Options Exchange Market Volatility Index (VIX). It uses options trades as a barometer for how volatile traders expect the market to be over the next month. Since it was introduced in January of 1993, the index has captured the interest of traders and investors alike, with the S&P 500 VIX Short-Term Futures ETN (VXX) coming in as the third most popular ETF, with average volume of almost 45 million shares.

But what does the VIX really mean? It’s known as the “fear index,” and generally believed to reflect panic in the markets. But is that what it’s really supposed to mean?

Calculating Volatility

Given its popularity, it should be important to note what, exactly, the VIX is supposed to track. It’s not a measure of present volatility. Nor is it technically a prediction of future volatility, though one could choose to read it as such. Rather, the VIX is a measure of current market sentiment regarding future volatility. Basically, what are today’s traders doing while they try to predict what’s going to happen over the next 30 days? When traders appear to be anticipating big moves in the market in the next 30-days, it should mean the VIX goes up. If they appear to be betting on smaller market moves, it goes down.

The benchmark that’s used to measure that current market sentiment is options trading. The method was developed by Prof. Menachem Brenner and Prof. Dan Galai in 1986 and then published in the July/August 1989 issue of Financial Analysts Journal. Without going to deep into options, they’re essentially contracts to either buy or sell stock at a certain price at a future date. Basically a way to bet on whether or not a stock will go up or down without actually buying the stock. The VIX tracks what options are being bought and sold, and how big the strike price on those options are. A larger strike price implies that the person buying the option forsees a bigger move in that stock’s price. So, if options are being written with larger strike prices, it probably means the market is anticipating bigger swings over the length of those options.

The Fear Index?

So, it should be noted that the index is not intended to be predictive. It’s measuring the current market sentiment about the next 30 days. Traders seem to believe that the S&P is going to make a big move, but that doesn’t mean that they’re right. In fact the correlation

It should also be noted that the index doesn’t indicate whether the anticipated movement is up or down. A large volume of traders buying call options with high strike prices would indicate they’re predicting a bull market, and it would also push up the VIX.

And this is important, because the perception of the VIX as the “fear index” appears to be inaccurate. It's not an indication that a major sell-off is forthcoming. In fact, it could mean just the opposite. The only thing a high VIX should mean is that people buying options are anticipating a lot of movement in the market over the next month. It doesn't really mean anything else.

Or does it?

A Self-fulfilling Prophecy

Perception can mean everything. And the idea that the VIX is the “fear index” is a powerful one. A sharp rise in the VIX is enough to make some traders sell off equities and shift into a risk-off environment. And, of course, if an increasing VIX results in people selling equities, it means it can result in the equities market falling anyway.

So whether or not traders really understand what the VIX means, the fact that they believe it’s the “fear index” makes it the “fear index” on some level. Which can mean that, despite what the VIX actually measures and should represent, the effect it has on the market ends up being that of a "fear index."

A Volatile Way to Trade

Ironically, what makes the VIX such a popular trading vehicle through its ETF is that it's so volatile. So the index tracking volatility is volatile. Go figure. The volume of shares trading hands on the major VIX ETFs proves that traders are interested in continuing to follow the "fear index."

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions.

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Results for VXX
Becky Hiu
18 Dec 14 11:28:45
$CL_F pressings LOD here. So, does it even matter? $VXX says yes it does cause it's only down 1.1% when the $SPY is up 1.7%.
Alysia Sarkisian
18 Dec 14 11:22:21
RT @SeekingAlpha: The Mistakes Smaller Investors Are Making http://t.co/cayTRr0MMl $TVIX $XIV $VXX
18 Dec 14 11:21:34
#CrudeOil continues to slide, I see that as a leading indicator for $SPY weakness coming. Back in some $VXX here. Fed announcement = fluff
18 Dec 14 11:20:03
RT @SeekingAlpha: The Mistakes Smaller Investors Are Making http://t.co/cayTRr0MMl $TVIX $XIV $VXX
Seeking Alpha
18 Dec 14 11:15:48
The Mistakes Smaller Investors Are Making http://t.co/cayTRr0MMl $TVIX $XIV $VXX
18 Dec 14 11:15:06
Is $VXX staying strong becuase $SPY is goin down? put buyer
Zero Filter
18 Dec 14 11:05:48
@steveliesman #CNBC Surprisingly cautious big moves up market post yet another #Fed #juiced rally $SPY $VXX
David Webb
18 Dec 14 10:50:27
Not much to say. Coasting on $vxx shorts til end of week. Pretty early to start loading negative delta. $spy $IWM
18 Dec 14 10:45:41
$vxx is down $twtr is up Life is good
Robin of the Hood
18 Dec 14 10:42:53
@JLoesser $VXX is so strong!!!
TV_Trading Ideas
18 Dec 14 10:34:42
$SPY $VXX $SDS Yesterday said that bears must be patience! $IWM http://t.co/FiWEDXXZz0
18 Dec 14 10:34:42
$IWM chart: $SPY $VXX $SDS Yesterday said that bears must be patience!. http://t.co/nZS2sBvWkG
18 Dec 14 10:30:36
$VXX should be down a lot more
Jeff C Brook
18 Dec 14 10:24:00
$NQ, $NDX % gains ready to outpace $VXX intraday % losses.
Common Man Investor
18 Dec 14 10:18:09
$VXX still being held back by price of Crude while the $VIX isn't. Interesting at least...
18 Dec 14 10:15:09
There was a $VXX volatility spike Jan-Feb this year. I'm preparing for a repeat in 2015, possibly earlier.
18 Dec 14 10:12:30
$VXX http://t.co/gTgmzWVLEY
18 Dec 14 09:59:53
#SENTISHIFTUP $SPX $SDRL $ENTA $VZ $BA $JPM $T $GS $VXX $JNK #quantheta #sentiquant 20141218 13:00:13:087
Carolyn B Miciano
18 Dec 14 09:15:06
Identify extreme conditions with oscillators http://t.co/7RSXgoYmUB $VIX $VXX $OEX
18 Dec 14 09:15:06
$VXX interesting that this is up from its low. $SPY seems to be holding steady.
18 Dec 14 09:05:04
Platinum Memberships Rose, After 528% Gains On Penny Stocks, In One Month! Big Update: http://t.co/2W3yKD2d5Q $LODE $VXX $RMKR
Investors Hangout
18 Dec 14 09:04:35
chartguy89: VXX Stock Chart $VXX $DIA $AGQ $XLP http://t.co/7bSzzajKlv
Investors Hangout
18 Dec 14 09:04:31
chartguy89: VXX Stock Chart $VXX $DIA $AGQ $XLP http://t.co/3K8D5QIKB3
18 Dec 14 09:02:50
chartguy89: Stock Charts: VXX Stock Chart $VXX $DIA $AGQ $XLP http://t.co/GCqlrFB4i2
18 Dec 14 09:01:25
VXX Stock Chart $VXX $DIA $AGQ $XLP http://t.co/n5TqTzoMhB http://t.co/b5oyjsNdDh
Enis Taner
18 Dec 14 08:59:36
Bought $VXX Jan15 28 calls this am. Realized vol in $SPY picking up, catching up to other asset classes. Will hold as long as $VXX above 28
Bruce J Moschella
18 Dec 14 08:59:29
$VXX $VIX $ZB_F $ZN_F A new report built for Firms and experienced discretionary money managers
18 Dec 14 08:49:26
As soon as it came, fear is gone again. $SVXY $VIX $VXX $UVXY $XIV $SPY $QQQ $DIA $IWM $TLT $MACRO
18 Dec 14 08:43:33
$VXX http://t.co/qtW5j9J3xS
Investors Hangout
18 Dec 14 08:35:44
danrocks: $JPM Is this one to watch? $SEE $GDXJ $VXX $FTK http://t.co/vj7E65JUAU
Investors Hangout
18 Dec 14 08:35:44
danrocks: $JPM Is this one to watch? $SEE $GDXJ $VXX $FTK http://t.co/fOEdC9YzQO
Robin of the Hood
18 Dec 14 08:31:06
$VXX very strong here.
Matthew Whiz Buckley
18 Dec 14 08:26:17
Market Situation Report: The Guns N' Roses Rally http://t.co/rH9xjSpWNZ $aapl $spx $vix $spy $VXX
18 Dec 14 08:18:00
$TLT 20+ Year Trsy Bond Ishares (TLT) 124.43 -2.00 (-1.58%) $AA $VXX $LNKD http://t.co/TAUpTx3mJz
18 Dec 14 08:13:29
$JPM Is this one to watch? $SEE $GDXJ $VXX $FTK $MA http://t.co/XqycbIhfoU
Robin of the Hood
18 Dec 14 08:09:18
$UVXY easy play today! $VXX flashed signals all morning.
18 Dec 14 08:09:04
$Vxx ripping
18 Dec 14 08:08:42
$VXX $UVXY also slowly grinding up from its lows all morning
Becky Hiu
18 Dec 14 08:02:24
Becky Hiu
18 Dec 14 07:59:41
$VXX flagging here
Lach 14
18 Dec 14 07:57:07
$SPY The $VIX down -25% from yesterday's open. Now -12% on day- total slam. $VXX, $UVXY http://t.co/ASzFQbJnQm
18 Dec 14 07:57:00
If $SPY starts to gap fill, $VXX will take off IMO
Becky Hiu
18 Dec 14 07:56:02
Very fact $VXX acting the way it is is because of oil. $CL_F
Becky Hiu
18 Dec 14 07:53:54
$VXX breaking out here
Daniel Anthony
18 Dec 14 07:52:28
"@HFTAlert: Dark Pools heavy sellers of $spy today. $VXX MP rising tells us they're buying protection. http://t.co/xVphkB51yZ"
Samantha LaDuc
18 Dec 14 07:50:54
RT @HFTAlert: Dark Pools heavy sellers of $spy today. $VXX MP rising tells us they're buying protection. http://t.co/SY2woGBCKO
Nils Tracy
18 Dec 14 07:48:34
RT @HVST: Nils Tracy crushing it. Moved up to 15th in our ranks. Long $XIV $UPRO, short $VXX, $UVXY. Check out his portfolio https://t.co/4…
18 Dec 14 07:47:42
RT @HFTAlert: Dark Pools heavy sellers of $spy today. $VXX MP rising tells us they're buying protection. http://t.co/SY2woGBCKO
Investors Hangout
18 Dec 14 07:46:43
DennyT: VXX Market Watch $VXX $FNMA $RSP $HOU.TO $AKS http://t.co/vaoNLuMrIF
Investors Hangout
18 Dec 14 07:46:40
DennyT: VXX Market Watch $VXX $FNMA $RSP $HOU.TO $AKS http://t.co/HSQitJk3Ud
By  +Follow October 14, 2013 8:46AM



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