The Right Way to Use the VIX to Profit and Avoid Losses

NEW YORK (TheStreet) -- There are many opinions and ideas about what the VIX is and what it indicates. The Chicago Board of Options Exchange (CBOE) introduced it in 1993, according to their VIX micro site and they discuss it openly.

The VIX evolved into the benchmark for stock market volatility. It's quite popular and is frequently mentioned in publications like TheStreet.

Since volatility can indicate financial risks and uncertainty, the VIX is often referred to as the "investor fear gauge".

What many investors want to believe is that the VIX predicts the stock market's direction, but that isn't what it was created to do.

According to economist Scott Brown (in a recent discussion I had with him on this topic), the VIX is a way of measuring "implied volatility" and is mainly a tool used by option market-makers and traders.

There is an Exchange-Traded-Note (ETN) that "seeks to replicate, net of expenses, the S&P 500 VIX Short-Term Futures Total Return Index." Called the iPath S&P 500 VIX Short-Term Futures ETN (VXX), it seems designed to almost mirror the direction of the VIX.

On March 26, VXX fell to a new 52-week low of $15.57, and it has stayed above that level since. Not until May 15 did the price go above $20.

But what good is VXX if an investor doesn't understand what the VIX was designed originally to measure.

Speaking of measurements, "implied volatility" measures the degree to which option sellers are anxious about current and future market conditions. Thus, according to Brown, the VIX "is forward looking".

He explained that Robert Whaleyof Vanderbilt University, the man credited with creating the VIX for the CBOE, realized that indexing values of implied volatility on SPX (S&P 500) futures would signal a warning of an impending, potentially severe stock market correction.

Whaley's original intention evidently was to index the implied volatility of SPX puts . He apparently realized that large institutional fund managers were buying these puts when they perceived a high probability of a major market downturn.

Brown explained that put sellers will respond to increased demand by increasing the prices (premiums) they charge for these protective puts.

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