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.
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.)
Select the service that is right for you!COMPARE ALL SERVICES
- $2.5+ million portfolio
- Large-cap and dividend focus
- Intraday trade alerts from Cramer
- Weekly roundups
Access the tool that DOMINATES the Russell 2000 and the S&P 500.
- Buy, hold, or sell recommendations for over 4,300 stocks
- Unlimited research reports on your favorite stocks
- A custom stock screener
- Upgrade/downgrade alerts
- Diversified model portfolio of dividend stocks
- Alerts when market news affect the portfolio
- Bi-weekly updates with exact steps to take - BUY, HOLD, SELL
- Real Money + Doug Kass + 15 more Wall Street Pros
- Intraday commentary & news
- Ultra-actionable trading ideas
- 100+ monthly options trading ideas
- Actionable options commentary & news
- Real-time trading community
- Options TV