Stock Quotes in this Article: VXX

BALTIMORE (Stockpickr) -- The VIX is everyone's favorite volatility gauge -- but do you really understand how it works?

Volatility has been through the roof in the past couple of months, and as a result, the VIX is becoming a popular trading tool. Knowing how the VIX works can mean the difference between making significant profits in a tough market and losing your shirt. In today's Technical Primer, we'll take a look at what this technical metric tells us and at how to use it effectively in your trades.

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It's worth starting off by explaining exactly what the VIX is. The VIX -- or more accurately, the Chicago Board Options Exchange Market Volatility Index -- is a measure of the implied volatility of S&P 500 index options. It's a measure of the volatility that's being priced into the market by investors.

That's a key distinction; the VIX isn't a statistical measure of market volatility. Because the VIX is based on what market participants think, it's subject to bias. That's a big reason for the index's moniker as the "fear gauge" -- it's a better indicator of how scared investors are right now than it is a meter of volatility in the stock market.

If you're looking for a way of measuring the amount of volatility in the market, there are plenty of tools available. Statistical measures of volatility, such as Bollinger bands or average true range, are a better option for investors who are looking to avoid the bias in the VIX.

Still, the VIX is popular for a reason: It can tell you quite a bit about market participants' mindsets. But what's it saying?

Interpreting the VIX

As I type now, the VIX is currently at 40.77. That number means that investors expect the broad market to swing 40.77% annualized over the next 30-days -- more simply, investors anticipate stocks to move 11.74% within the next month.

You can calculate the monthly expectations for the VIX yourself by taking its current value, then dividing by the square root of 12. (For those who are interested, it's because there are 12 months in the calendar year -- the square root is a result of the statistical definition of volatility.)

Remember, the VIX is a quantitative reading of fear in the market. The higher the number, the higher the price swing expectation in the S&P 500, and the higher the fear level in the market. Part of the reason for that is the bias that I mentioned earlier; historically, the VIX index reacts disproportionately to declines in the S&P 500. Put another way, given a loss of 5% in the S&P 500 followed by an offsetting gain of 6%, the VIX will generally decrease on day 2, even though volatility (the swing in price action) actually increased.
In other words, the VIX is inversely correlated with the S&P 500. That directional bias is important to remember when it comes time to use the VIX as a tool for real trading.
 

Trading the VIX

The VIX isn't just a measure of "fear" in the markets -- it's also a tradable instrument. Starting in 2004, traders have been able to get exposure to the VIX through futures, then futures options, and now exchange-traded products.
Trading the VIX became popular in the wake of the 2008 financial crisis because of its inverse correlation with the broad market. But there are some problems with trading the VIX directly.
The most accessible (and popular) VIX instrument is the iPath S&P 500 VIX Short-Term Futures ETN (VXX), an exchange traded note that most investors believe tracks the VIX Index. It doesn't. Instead, it attempts to track the performance of an index of VIX futures, as do all of the other VIX ETFs and ETNs out there.

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That means that VXX is literally a derivative of a derivative of a derivative of a derivative. Having an exchange traded note that's so far removed from its "underlying" asset is problematic. The biggest issue is that VXX muffles the returns of the VIX itself. It's also important to remember the fact that the product is an ETN, which means that investors who hold VXX are exposed to counterparty risk.

Another concern with trading the VIX (in any of its forms) is that most traditional technical analysis techniques don't apply. That's because supply and demand in the market aren't the arbiters of the value of the VIX; the mathematical model is. Technicals work because they help traders identify pockets of supply and demand; those buying and selling pressures are irrelevant in the VIX because its underlying isn't price-based.

Generally, volatility is mean reverting. That means that it reaches extremes, but it eventually returns back to its "normal" zone. VIX traders are essentially trying to pin a timetable on when it'll get back to normal.
Investors with more sophisticated (and risk-driven) approaches may find value in gaining some exposure to the VIX. For aspiring traders, though, I wouldn't recommend it; while some professional traders can consistently trade the VIX successfully, they turn to a different toolbox to do it. If you're just looking for inverse correlations with the S&P 500, there are plenty of "safer" ways to do it. So, how can you use the VIX?

A Contrarian View of the VIX

For short-term traders, the VIX is a valuable metric that can color your market analysis. Because the VIX gives you a direct estimate of fear in the S&P 500, it's a priceless detail about market psychology that's quantified in real time.

It's also valuable for longer-term investors when viewed from a contrarian angle.

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The old saying to "buy when the VIX is high and go when the VIX is low" has historically been pretty good advice. Because the VIX measures fear (and it's directional), extremes in the index can indicate the same sorts of extremes in sentiment that provide contrarian buying opportunities.

Yes, the VIX is a powerful tool that traders and investors can use to better understand what's going on in the market and increase their profits. But like any powerful tool, it can be incredibly damaging to your portfolio when applied incorrectly. Use the VIX for what it is, and you'll be better-prepared than the guy on the other side of the trade.

Next time, we'll add to your technical repertoire with another primer that will bring you closer to implementing technical analysis for your portfolio.

In the mean time, do you have a burning technical analysis question? Get it answered by heading to Stockpickr Answers.

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Jonas Elmerraji, based out of Baltimore, is the editor and portfolio manager of the Rhino Stock Report, a free investment advisory that returned 15% in 2008. He is a contributor to numerous financial outlets, including Forbes and Investopedia, and has been featured in Investor's Business Daily, in Consumer's Digest and on MSNBC.com.