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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
26 Nov 14 22:58:32
VXX -1.55% Stock Charts $VXX Barclays Bank PLC iPath S&P 500 VIX Short-Term Futures ETN (NAR) Any opinions on http://t.co/tPNEpuk7bB
26 Nov 14 22:11:48
“@SeekingAlpha: Why I Closed Out My Gold Short http://t.co/64Xj9TLFJe $GDX $GG $GLD $NUGT $SLV $VXX” $gdxj $jnug $jdst
Mark Yusko
26 Nov 14 22:07:38
#VariantPerception RT “@SeekingAlpha: Why I Closed Out My Gold Short http://t.co/EQiejih4Sk $GDX $GG $GLD $NUGT $SLV $VXX”
26 Nov 14 21:18:11
Our Penny Stock Pick On $STTK Is Up 128.57% In 2 Days! Major Update: http://t.co/oR27rFfh2v $LODE $VXX $RMKR
Quantpost Basic Mats
26 Nov 14 20:39:59
$GG News: "Why I Closed Out My Gold Short $GDX $GG $GLD $NUGT $SLV $VXX …" http://t.co/omrIersAxu Board view: https://t.co/6tY4UEtCLT
Seeking Alpha
26 Nov 14 20:39:57
Why I Closed Out My Gold Short http://t.co/iTPULTNlnw $GDX $GG $GLD $NUGT $SLV $VXX
26 Nov 14 19:27:34
@DowdEdward $vxx
26 Nov 14 18:35:15
@stockoptiondude as long as the $vxx does not hit your strike the call option expires worthless and you keep the premium collected.
brian stu
26 Nov 14 18:28:01
@theregans that's something I don't understand but want to? Talking about selling OTM calls on $vxx right?
brian stu
26 Nov 14 18:26:36
@theregans $vxx and $xiv r the easiest trades in my opinion if u know your economic business cycles.
26 Nov 14 18:25:41
@stockoptiondude I am amazed at the ROI one can get from selling premium on $VXX
26 Nov 14 17:00:58
@stockoptiondude All time low for the year. If it isn't in now then when? $VXX
brian stu
26 Nov 14 16:29:43
Prolly gonna sell my $xiv Friday. Not fearing a market sell off. Just thinking a $vxx floor might b nearing. Just a thought
26 Nov 14 15:12:25
Please swallow all food and drink before reading this: Stocks to Crash 50% http://t.co/Kx9NxEWZYb $SPY $DIA $TLT $VXX $GLD $AAPL
Carolyn B Miciano
26 Nov 14 14:07:54
Why Calendar spreads are a popular Options strategy http://t.co/flqoDM0N4y $VIX $VXX $OEX
26 Nov 14 13:44:06
RT @VixCentral: $VIX futures contango settled at 10.21% It is very expensive to hold $VXX and $UVXY long term. Happy Thanksgiving to everyb…
randall millard
26 Nov 14 13:40:17
RT @VixCentral: $VIX futures contango settled at 10.21% It is very expensive to hold $VXX and $UVXY long term. Happy Thanksgiving to everyb…
Eli Mintz
26 Nov 14 13:37:52
$VIX futures contango settled at 10.21% It is very expensive to hold $VXX and $UVXY long term. Happy Thanksgiving to everybody.
26 Nov 14 13:36:25
$VXX http://t.co/HJomaeymX3
26 Nov 14 13:08:04
US stocks close at record highs http://t.co/CrU0szWhow $SPY $DIA $VXX $FB
Carolyn B Miciano
26 Nov 14 12:53:39
What is Pattern day trader rule http://t.co/fCYkbbqyYc $VIX $VXX $OEX
26 Nov 14 12:52:08
Trading Volatility (#VRPStrategy) on Wed., 11/26/2014: Long $VXX closed, switch to $XIV (market-on-close). http://t.co/VaqWnlQjDj
Investors Hangout
26 Nov 14 12:26:35
lookn4wins: VXX -1.22% Stock Charts $VXX Barclays Bank PLC http://t.co/nrb3pxd6qu
Investors Hangout
26 Nov 14 12:26:35
lookn4wins: VXX -1.22% Stock Charts $VXX Barclays Bank PLC http://t.co/lApwni0iTy
Market Int Center
26 Nov 14 12:17:45
Potential Ipath VIX Short-Term Futures ETN $VXX Trade Targets 12.57% Return ( http://t.co/FH3NNZ84IY )
26 Nov 14 12:11:18
VXX -1.22% Stock Charts $VXX Barclays Bank PLC iPath S&P 500 VIX Short-Term Futures ETN (NAR) Any opinions on http://t.co/Gu4Zn5XDNU
26 Nov 14 11:59:31
Our Penny Stock Pick On $STTK Gained 171% And Closed up Over 85%! Huge News: https://t.co/MMLz0V8NAH $LODE $VXX $RMKR
26 Nov 14 11:57:43
Trading Volatility (#VRPStrategy) on Wed., 11/26/2014 (preliminary estimate): Long $VXX closed, switch to $XIV (market-on-close).
26 Nov 14 11:42:45
$vxx getting bought on last 2 bb pinches... looks like low in for the day. W/ OPEC tomorrow, would not short here
Main Street Alpha
26 Nov 14 11:17:28
DOO: Taking off the rest of the $TLT Calls and the nickle on $VXX Calls.
26 Nov 14 11:15:11
I wonder what would happen if you sold $VXX short right now.... #RISKFREESANTA
Options TradingIQ
26 Nov 14 11:00:25
Anatomy Of A Post Earnings Volatility Crush – $NFLX http://t.co/yvsEcrvloa $VIX $VXX $AAPL My #blog archive
26 Nov 14 10:59:58
It's really quite shocking that $SPY $VIX $VXX oblivious to oil here. Credit defaults are in no way priced in. Maybe not, but leverage huge
John Constantine
26 Nov 14 10:52:03
RT @jimcramer $UVXY $TVIX smackdowns for Holiday - $VXX $VIX $VX_F Free cash for Turkey Day - We never go down. #CNBC
Samantha Lee
26 Nov 14 10:51:46
"@JFinDallas: Pre-holiday market, like a #SqueezeFriday environment but on steroids... $ES_F $NQ_F $SPY $VXX"
Jim Smythe
26 Nov 14 10:51:20
$UVXY $TVIX smackdowns for Holiday - $VXX $VIX $VX_F Free cash for Turkey Day - We never go down.
Jean Fonteneau
26 Nov 14 10:50:43
Pre-holiday market, like a #SqueezeFriday environment but on steroids... $ES_F $NQ_F $SPY $VXX
26 Nov 14 10:49:50
$VXX VIX Short-Term Futures ETN Ipath (VXX) 26.63 -0.49 (-1.81%) $VZ $GS $SUPN http://t.co/Gha0YNSqdT
Carolyn B Miciano
26 Nov 14 10:41:48
How to use #Fibonacci in trading http://t.co/QZ4hT6YDQs $VIX $VXX $OEX
Jean Fonteneau
26 Nov 14 10:37:02
$VXX celebrating Thanksgiving with a fresh new all time low, neat, that one you can always rely on... $TVIX $UVXY
Chris Torchiana
26 Nov 14 10:32:53
$VXX and NYNL are in conflict which will be right? Breadth not in agreement either . . .http://t.co/4XbMnoidzo
26 Nov 14 10:28:20
RT @BT24_7: $VXX slam allows $SPY to break intraday range
Brandt Hackney
26 Nov 14 10:26:50
$VXX slam allows $SPY to break intraday range
Quantitative Trading
26 Nov 14 10:20:08
@biotech_trader2 if we reverse and close green on $vxx then yes 9/22 is a map.Else we make news lows and reverse split like so many times b4
26 Nov 14 10:19:10
AAPL Stock Chart $AAPL $VXX $SMN $SQQQ http://t.co/3vUo3LaFWl http://t.co/IXufid0PCa
Sain Ozdemir
26 Nov 14 10:17:09
@SainOzdemir New Lows $VXX
26 Nov 14 10:04:40
$VXX finally made a new low. It was about time.
Penny Stock Secret
26 Nov 14 09:56:40
$71,000 in ONE TRADE!! By Follwing Their Signals More Info Here http://t.co/SVqoMlijqL .. $LODE $VXX $RMKR
Jon Vince
26 Nov 14 09:25:29
Took $100 loss on $VXX...guess my radar snapshot was off on that one. Still keeping $TZA - that's a true hedge
Kym L
26 Nov 14 09:24:40
$VXX at Sept lows
By  +Follow October 14, 2013 8:46AM



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