How to Profit on Stock Market Volatility

NEW YORK (TheStreet) -- Imagine if we knew the level of confidence investors had in the markets on any given day. I can't teach you how to read minds. What I can suggest is looking at the S&P 500's "Fear Gauge," which may be the next best thing.

Volatility is currently running high in the stock market. Conventional thinking suggests that more volatility brings greater risk, which in turn allows for greater potential reward or loss. I've written in the past about my passion for trading stocks with high volatility and have explained how I successfully traded highly volatile individual stocks. Today's question goes beyond trading individual stocks to understand how to trade stock market volatility.

First, how do we measure stock market volatility? Enter the VIX. The VIX, also known as the Fear Gauge of the stock market, traces the volatility of the S&P 500.

Below is the formula for measuring the VIX. The VIX is reported daily, but is calculated repeatedly on the day. The VIX =

(Here are more details on calculating the VIX.)

Put in simplest terms, this formula shows expected volatility by averaging out-of-the-money Put and Call Options every day to  measure the expected annualized movement of the 30-day expected volatility of the S&P 500 index.

For concrete examples, here are some VIX spikes on notable dates in history.


It appears from the information in this table that the VIX rises abruptly in response to (and possibly in anticipation of) negative events. The highest VIX spike I found was a spike to 150 during the October 1987 crash, although according to the CBOE Web site, the VIX Index hit its all-time intraday high of 89.53 on Oct. 24, 2008.

This is a discrepancy requiring further research, but it is interesting to note and appears possible. The VIX also responds positively (goes down) when an event perceived as positive occurs. The VIX went from 60.17 on Nov. 3, 2008 to 53.68 on Nov. 4, 2008, then to 47.73 on Nov. 5, 2008, after the election of President Obama.

It appears that the VIX measures both volatility and bearish or bullish market sentiment based on the CBOE definition and formula, and based on empirical evidence showing VIX movement in relation to world events.

So, then, how to you trade on stock market volatility? You cannot trade shares of the VIX because it is an index, but you can trade the VIX in the following ways:

1. Futures on the VIX: According to Reuters, trading volume in VIX futures hit an all-time high in January 2014, suggesting investors were buying protection against a market decline. The VIX futures trading volume totaled a record 4.40 million contracts, a 52% increase from a year ago and a 38% increase from December.

2.
Options on the VIX.

3.
Exchange-traded products such as the iPath S&P 500 VIX Short-Term Futures ETN (VXX) and the related (VXZ). These two exchange-traded notes are complicated because they are a cross between bonds and exchange-traded funds. Trading ETNs is tricky because the change in price of an ETN may sometimes have little to do with the underlying index but instead be related to a downgrade or upgrade in the issuing bank's credit rating. Head spin. Plus, some of the ETNs are (or used to be) leveraged products, which makes (or made) them super-risky.

Soooooo... maybe I'll go back to trading individual stocks while keeping an eye on Bollinger Bands, the VIX and other volatility indicators or maybe I'll focus more on these more complex ways to trade volatility. Whichever way you trade stock market volatility, I wish you success.

Many Happy Returns,

Rachel

At the time of publication the author had no position in any of the stocks mentioned.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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