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These days there's a lot of chatter about the Chicago Board Options Exchange's

Volatility Index and its predictive value. The VIX, as it's better known, was officially acknowledged by the CBOE in 1993, but has data going back to 1983 when index options first began trading.

Before we get into the index's value as a "bearish" or "bullish" indicator, let's supply the definition of how its absolute value is derived. I think a lot of people talk about the VIX, assured that 10 is "low" and 50 is "high," without really knowing how or where that number is reached.

The VIX is calculated by taking a weighted average of the implied volatilities

implied volatility of eight

Standard & Poor's 100 Index

(OEX) OEX options. The chosen options, four puts and four calls, straddle the index's current price and have an average time to maturity of 30 days.

For example, on Nov. 25, with the OEX at 477, the strikes used would be the December 475 and 480 puts and calls and the January 475 and 480 puts and calls. With 28 days remaining until the December expiration and 54 days to the January expiration, more weight will be placed on the December options. The VIX is calculated on a continuous, rolling basis providing a general representation of volatility in the overall equities equity market.

Bullish? Bearish? Which Way Should I Go?

In the world of text books, volatility is only supposed to provide an indication of the likelihood and amplitude of a price change,

not

the direction. But in the real world, the VIX has proven itself as an accurate contrarian market indicator. When the VIX hits extreme levels, indicating undue bearish or bullish sentiment, the market typically reverses direction.

The underlying theory is that at any given moment in time the majority opinion is wrong. A rising stock market is viewed as less risky than a declining stock market. The higher the perceived risk is in stocks the greater the demand for protective options, driving up prices and sending implied volatility higher.

Hence, if everyone is in a panic, selling stocks and buying puts, the bottom might be at hand. While the theory relies more on art than science (certainly more psychological than economical), it has proven to be historically reliable.

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Looking at the chart below you can see how extreme readings (above 45) have marked major market bottoms and ensuing rallies.

Note that as a contrary indicator the VIX is more reliable defining market bottoms, expressed in extreme "fear," or high volatility, rather than flagging tops based on "complacency," or low volatility.

Aside from its predictive nature, the VIX can be helpful to traders by indicating whether options are "cheap" or "expensive." Being aware of the relative value of what you are buying or selling is always crucial in options trading.


Source: CBOE


Source: CBOE

If you buy a call in anticipation of a rally but you pay too much, potential profits might be negated if a drop in the volatility offsets any gains in the underlying asset. Option traders always want to have the wind at that their backs -- in other words, buy cheap and sell expensive. This is the opposite of when using the VIX as a market prognostication tool -- then the rule of thumb is buy when high.

To illustrate how volatility impacts the price of options, below is a span sheet similar to those used by traders showing the price changes in a near-term at-the-money put and call based on various implied volatilities. This is a snapshot of theoretical values of the December 475 straddle with the OEX trading at 477 and 28 days remaining until expiration.

Assuming all else remains the same, a shift in volatility from 20 to 50 will cause a corresponding 149% price increase, from $20.33 to $50.60, in the value of the at-the-money straddle. Since value levels are all relative, it may be worth considering that, given the VIX's long-term upward trend, the trading range defining cheap vs. expensive may have inched up.

The VIX has been trending up since options first started trading on the OEX in 1983. In fact, until October 1987, when it spiked to an eye-popping level of 110 (reaching almost 160 intraday) the VIX had never crossed 30.

Through the first half of the 1990s the range was 10 to 20. From roughly 1996 through 2001, the VIX was between 20 and 30. During the first half of 2002 the range was 20 to 25, crossing 30 for the first time in June. Now after hitting 55 and 50 during the July and October lows, respectively, the VIX has dipped back below 30 for the first time since June 18.

Whereas five or 10 years ago the VIX hitting 30 might have flagged a straddle sale trade, now it may represent a buying opportunity. Only after implied volatility becomes historical will we know the answer.

Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

Steve Smith.