I know you've written about the VIX frequently (and think it may be overcovered), but would you mind commenting on the CBOE's new VIX formula and how some of the proposed products might be utilized? Keep up the good work. -- D.G.

Last week, the Chicago Board of Options Exchange announced it will reformulate the calculation for its widely followed volatility index, commonly known as the VIX. More important, it has proposed to offer tradeable futures and options products based on the new VIX index. It will be released and applied on Sept. 22. The "old" VIX will continue to be tracked under its

existing formula with the symbol VXO. The new products are slated for launch sometime during the fourth quarter of 2003.

New Formula, Same Taste?

The two main differences of the updated VIX are that it will be based on the

S&P 500

Index (SPX) options rather than the S&P 100 Index (OEX) options, and the new formula will include a much broader range of strike prices with the at-the-monies strikes having the most weight. The old formula used just eight strikes based on 30-day at-the-money options. The goal of these two changes was to broaden the representation of overall market volatility and, therefore, its appeal and applications. A surfeit of information concerning the methodology can be found on the

CBOE Web site.

Given that the S&P 500 and its options are a much more widely followed and traded benchmark than the OEX, I think the CBOE's goal will be achieved. Those who like the VIX as a contrary indicator should note that the broadening will have a dampening effect on the readings. For example, when the VIX hit a peak of 54.8% in July 2002, the "new" VIX would have only recorded a level of 45.3%. This speaks to a topic I've discussed frequently of not getting too caught up in the VIX's absolute level but rather focusing on the change in relative price and direction. In this respect, I think the VIX will still provide a reliable contrary indicator, especially for flagging oversold conditions or marking market bottoms.

More Products, More Better or Merely Mire?

For the average individual investor, the changes to the index will have minimal impact, but for active traders, especially those using options, the myriad possible applications are, if not yet entirely clear, certainly enticing.

One of the first concepts to grasp is that since volatility typically rises as the market declines, one would buy calls on the VIX (or sell puts) to gain a profit or get protection from a sharp decline in the S&P 500.

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For example, assume you go long the S&P 500 in the form of individual equities, an index or mutual fund, or options on any of these underlying equity investment vehicles. A typical protection would be to buy puts. A main difficulty in buying put protection is gauging what strike price will deliver the desired protection at minimal expense. This is because as the underlying price rises, the put moves further out of the money and becomes increasingly subject to time decay, decreasing its absolute and protective value.

On the other hand, the VIX may trade at a fairly constant level even as the underlying price increases, so an alternative might be to purchase out-of the-money VIX calls, such as a 30 strike, under the premise that the VIX will only rise significantly if the S&P 500 drops dramatically. The advantage of this is no matter what level the S&P starts to decline from, the 30 calls should still be the same distance from the money as when first purchased.

Other trading and strategies include hedging, such as buying straddles on a stock or underlying index and selling VIX premium, or outright trading of volatility with VIX options without regard for market direction. Note that the historical volatility of the VIX over the past five years has been nearly 78% based on a 50-day moving average.

This brings up an important point raised by a reader email concerning a recent

column on selling calls.

Steve,The idea of receiving a premium for selling a call may seem enticing whenstocks have risen so quickly, but buying puts is amuch safer way to play the shorting game even though you are paying outmoney to do this. If the VIX was trading above 50%, then I might agree withyou, but implied vol is historically low in the short run and thereforeoffers a better buying opportunity than selling vol (i.e., buying puts instead of selling calls). -- M.W.

Remember: The VIX measures the volatility of the broad market. It shouldn't be used for extrapolating a blanket assessment on whether options or individual issues are "cheap" or "expensive." Just because the VIX is trading at 19% doesn't mean

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calls at 56% are cheap.

Steven Smith writes regularly for 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 was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He invites you to send your feedback to

Steve Smith.