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Trading the VIX: What You Need to Know

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So you think you’re ready to trade the VIX through its futures, options, or ETFs. I’ve got news for you: most traders have no idea what they are looking at when it comes to anything to do with the VIX.
Since there is so much focus on the VIX as the "fear gauge" and because it is used as a fairly reliable sentiment indicator by traders, it helps to truly understand how it is calculated and what its fluctuations represent. 
First off, we need to know that volatility is simply good old standard deviation. And "vol" numbers like the VIX are expressed as annualized standard deviation. A VIX at 40 means that the market is expecting the S&P 500 to be within 40% up or down, one year from now, in about 68% of cases.
You might wonder how useful it is to talk about "where the market will be one year from now, 68% of the time." I address that in my article Demystifying the VIX and show you a better way to think about this most-misunderstood barometer of risk using a special math “magic trick.”
Right now, let's see how the VIX is constructed. 
While there can be volatility measures of the historical price movement of a stock or an index, the VIX is built from the "implied" vol of options prices on the S&P 500 index. 
Implied volatility tells you what the market "thinks" is going to be the actual volatility of the underlying instrument as seen through the prices being paid for its puts and calls. In this way, option prices "imply" the expected volatility. 
At the Chicago Board Options Exchange, owned by CBOE Holdings (CBOE - Free Report) , the SPX is a real-time measure of the S&P 500 stock index. SPX options are traded off of that real-time calculation, though there is no actual trading of the index itself there. 
Big Money, Big Risk
Though related, the SPX and VIX should not be confused with the CME Group (CME - Free Report)  S&P 500 futures contract, which also has its own options. The SPX is considered the cash or "spot" index and the futures have a forward delivery date on the March quarterly cycle. 
Both are vital instruments for the hedging of risk by institutional portfolio managers. Without them, the stock market would not have the liquidity and depth it does. 
And this brings up the point about why the implied volatility of SPX options as expressed through the VIX is so important. Because large portfolio managers who don't want to sell their stocks need to use SPX puts and calls to hedge. This means that SPX options are very liquid. You also have a fair amount of hedge funds using SPX options to speculate on index moves. 
The VIX Recipe
The actual calculation of the VIX can be a little complicated. It involves the real-time weighting and blending of dozens of out-of-the-money (OTM) call and put implied volatilities. Imagine the SPX at 1,200 and think of all the upside OTM calls from the 1,210 strike on up and all of the downside OTM puts from the 1,190 strike on down. 
All of these option strike prices imply their own volatility and are part of the VIX calculation that strives to get a realistic, real-time picture of what investors are paying for protection. 
The VIX is also based on options from the first two contract expirations being traded at any given time. These are further blended to get an accurate 30-day rolling "window" on SPX implied volatility. 
If you are interested in the full break down on the VIX calculation, go to the CBOE website and find their excellent white paper explaining all this in detail. 
That’s enough of “VIX class” for now. If you want more, watch the video that accompanies this article where you will find out about my other article VIX: 7 Things You Need to Know, plus a great special and free tool to watch the VIX “futures curve” in real time.
Kevin Cook is a Senior Stock Strategist for Zacks where he runs the Market Timer portfolio.

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