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Lesson 6: The VIX

VIX is a ticker symbol for the CBOE Volatility Index, a popular measure of the implied volatility of S&P 500 index options. Often referred to as the fear index or the fear gauge, it represents one measure of the market's expectation of stock market volatility over the next 30 day period. The VIX is quoted in percentage points and translates, roughly, to the expected movement in the S&P 500 index over the upcoming 30-day period, which is then annualized. "VIX" is a registered trademark of the CBOE.

The VIX is a measure of market perceived volatility in either direction, including to the upside. In practical terms, when investors anticipate large upside volatility, they are unwilling to sell upside call stock options unless they receive a large premium. Option buyers will be willing to pay such high premiums only if similarly anticipating a large upside move.

Think of flood insurance, you only buy flood insurance if you think it can flood, and the more likely a flood is the more the insurance costs. The VIX is like measuring the percentage CHANGE Up or DOWN in the insurance cost. Obviously this is going to be volatile on the changing edge of the flood zone. 

The resulting aggregate of increases in upside stock option call prices raises the VIX just as does the aggregate growth in downside stock put option premiums that occurs when option buyers and sellers anticipate a likely sharp move to the downside. When the market is believed as likely to soar as to plummet, writing any option that will cost the writer in the event of a sudden large move in either direction may look equally risky.

Hence high VIX readings mean investors see significant risk that the market will move sharply, whether downward or upward. The highest VIX readings occur when investors anticipate that huge moves in either direction are likely. Only when investors perceive neither significant downside risk nor significant upside potential will the VIX be low.

That said, you must remember that stocks move up gradually and come down quickly, so in reality a fast rising VIX more often means the market is in a sell off.

This is the chart we use in the Market Comment:
It has three components, in the center is the classic VIX, overlapped with green and red bars indicating recent ranges for over bought and sold. This drifts over time, so the line become adjust now and then, as the VIX move in to new territory.

On the bottom is the price of the equal weighted S&P500 using an ETF called RSP. Equal weight indexes are a little more in tune with the market than cap weighted index (read why here). The colors are based on Elders Impulse System (read more here).

On the top of the chart is the Commodity Channel Index, (read more here). As you can see when it gets into the green we are too high-ish and the brown is too low-ish, I added the ishes, because it can be in these extreme reading a while.  Normal it will revert-to-the-mean (go back) but no immediate promises.

The VIX acts a lot different in a surprise like 9/11 than in a slow drip of human made information of trouble, like the 2008 financial crisis.

The VIX is based on 30 day options, but there are also long dated options on the vix and the Market Comment has an experimental chart called the VIX Evaluator that compares the differential of two VIX ETNs VXX (short dated) and VXZ (mid term dated)

Here is the chart:

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