With all of the market hoopla over the past few weeks, you might have heard a few foreign terms floating around. Today I’ll break down one of those random acronyms – the VIX– into non-technical language that actually makes some sense.

What is the VIX?

The VIX is the Chicago Board Options Exchange Market Volatility Index. In non-eye glazing terms, it’s a measure of the expected volatility of the S&P 500 index over the next 30 days (the S&P 500 being an index that represents the stock market overall).

The VIX is also known as the “fear index,” because it tends to shoot up when the market goes bad and stock prices fall. When the VIX hits 20 it generally means the market is falling. When everyone was predicting a market correction and the VIX shot to 30 last week, investors were basically doing this:

The index is calculated based on the prices of options on the S&P 500 index. An option – specifically called a call or a put – is a contract you buy that gives you the right to buy or sell a stock at a specified price.

For example, I could buy a call option that gives me the right to buy Apple (AAPL) for $105 within the next 30 days. If the price of Apple increases to $110 I get an automatic $5 profit, since I can buy the security at a lower price than it’s trading for. If Apple stays below $105 for the next 30 days, the option expires.

The market’s volatility and options prices are connected because as the market gets more volatile, stock prices tend to swing more widely. If a stock is experiencing large price swings, there’s more of a chance your option will hit its target price (will be “in the money”), and therefore the option becomes more valuable. So higher option prices mean a higher volatility, and therefore a higher VIX.

As I mentioned earlier, you can use high VIX numbers to tell you how badly the market is doing. When the market was sputtering last week the VIX shot to 30, but back in 2008, during the crash and recession, the VIX got all the way up to 79.

 

VIX

Here’s the catch…

In theory, the VIX would be a great hedge on your portfolio. Hedging just means you are adding in securities that reduce the risk of your portfolio (although they also reduce the return potential). To hedge, you add in securities that move in the opposite direction of what you hold. In this case, the VIX will rise when the market falls, so you won’t lose as much overall even if the market tanks.

The issue is you can’t actually trade the VIX. There are a few securities that are set up to mirror the VIX, such as TVIX and VXZ, but they are too delayed to accurately predict the next 30 days. So even though the % return of the VIX is beating the return of the S&P 500 year to date, the securities that track it have a negative return so far in 2014.

If you are interested in using volatility as a hedge, you should only use these products as short term trades due to their limitations. I’d only buy them if you think additional volatility is imminent (i.e. if you bought at the beginning of October) and sell once you see volatility spikes (i.e. last week). That way you can lock in some short term gains to balance out the dips in your holdings.

For those of you who aren’t actively trading, that’s not really a realistic strategy. Therefore, ignore the trading possibilities and just enjoy the feeling that you know one more random word than the next finance know-it-all you meet.

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