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How to Trade the VIX

Stocks in this article: VXX

BALTIMORE ( Stockpickr) -- The VIX is everyone's favorite volatility gauge -- but do you really understand how it works?

Volatility has been through the roof in the past couple of months, and as a result, the VIX is becoming a popular trading tool. Knowing how the VIX works can mean the difference between making significant profits in a tough market and losing your shirt. In today's Technical Primer, we'll take a look at what this technical metric tells us and at how to use it effectively in your trades.

>>5 Sentiment Indicators to Keep an Eye On

It's worth starting off by explaining exactly what the VIX is. The VIX -- or more accurately, the Chicago Board Options Exchange Market Volatility Index -- is a measure of the implied volatility of S&P 500 index options. It's a measure of the volatility that's being priced into the market by investors.

That's a key distinction; the VIX isn't a statistical measure of market volatility. Because the VIX is based on what market participants think, it's subject to bias. That's a big reason for the index's moniker as the "fear gauge" -- it's a better indicator of how scared investors are right now than it is a meter of volatility in the stock market.

If you're looking for a way of measuring the amount of volatility in the market, there are plenty of tools available. Statistical measures of volatility, such as Bollinger bands or average true range, are a better option for investors who are looking to avoid the bias in the VIX.

Still, the VIX is popular for a reason: It can tell you quite a bit about market participants' mindsets. But what's it saying?

Interpreting the VIX

As I type now, the VIX is currently at 40.77. That number means that investors expect the broad market to swing 40.77% annualized over the next 30-days -- more simply, investors anticipate stocks to move 11.74% within the next month.

You can calculate the monthly expectations for the VIX yourself by taking its current value, then dividing by the square root of 12. (For those who are interested, it's because there are 12 months in the calendar year -- the square root is a result of the statistical definition of volatility.)

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