Todd MitchellCBOE Volatility Index (VIX), a measure of the implied volatility of the S&P 500 stock index, which skyrocketed after the global melt down began in earnest in August. You may know of this from the talking heads, beginners, and newbies who call this the “Fear Index”.

For those of you who have a PhD in higher mathematics from MIT, the (VIX) is simply a weighted blend of prices for a range of options on the S&P 500 index. The formula uses a kernel-smoothed estimator that takes as inputs the current market prices for all out-of-the-money calls and puts for the front month and second month expirations. The CBOE Volatility Index is the square root of the par variance swap rate for a 30 day term initiated today. To get into the pricing of the individual options, please go look up your handy dandy and ever useful Black-Scholes equation. Got all that?

For the rest of you who do not possess a PhD in higher mathematics from MIT, and maybe scored a 450 on your math SAT test, or who don’t know what an SAT test is, this is what you need to know. When the market goes up, the (VIX) goes down. When the market goes down, the (VIX) goes up. End of story. Class dismissed.

The (VIX) is expressed in terms of the annualized movement in the S&P 500. So if today’s (VIX) is $42, it means that the market expects the index to move 12.13%, or 137 S&P 500 points, over the next 30 days (17.62/3.46 = 12.13%). It really doesn’t care which way. If the S&P 500 moves less than that, you make a profit on your short (VIX) positions.

It gets better. Futures contracts began trading on the (VIX) in 2004, and options on the futures since 2006. Since then, these instruments have provided a vital means through which hedge funds control risk in their portfolios, thus providing the “hedge” in hedge fund.

But wait, there’s more. Now, erase the blackboard and start all over. Why should you care? You can use options strategies to create a cheap entry point and to limit your risk. Implied volatilities can be absolutely through the roof. So just buying the puts outright in those situations could be insanely expensive and risky. Better to make the trade volatility neutral.

About the Author Todd Mitchell

Todd Mitchell is the CEO & Founder of Trading Concepts, Inc. He's been trading since 1994 and has mentored over 12,000 traders from Wall Street to Main Street. He's an expert at developing strategies for creating more consistent daily, weekly and monthly income.


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