Ask a Broker

December 2006

This month, Lind Plus Senior Market Strategist Matt Krupski discusses the VIX, and why futures traders might be interested in following its movements.

Q: I trade financial futures markets and keep hearing about the level of the VIX mentioned in the press. What is it, and how can I use this information?

A: The CBOE Volatility Index® (VIX®) is a key measure of market expectations of near-term volatility conveyed by S&P 500® stock index option prices. Since its introduction in 1993, VIX has been considered by many to be one of the key barometers of investor sentiment and market volatility. Derived from the value of the S&P options, the VIX essentially measures what investors forecast for the future volatility of the index. If investors are concerned about future market volatility, they are more inclined to buy options (either in an effort to protect futures positions or take advantage of anticipated large price swings).

Simple supply/demand basics hold that as the demand for options increase, so does their price. As their price increases due to the added demand, their implied volatility increases, as does the derived value of the VIX. For this reason, the VIX is sometimes referred to as a "fear gauge." A low level of the VIX implies investors are more or less complacent: they are not worried about protecting positions or anticipating large price swings with options, and prices for equity options will be less expensive due to less demand. If the VIX declines to a significant degree (such as where we are currently) buying options can be an attractive opportunity, as low implied volatility equates to cheaper option premiums.

If you trade equity index markets, you should pay attention to the VIX because it gives a window into what other market participants may be anticipating. Because it is derived from implied volatility, it conveys what traders expect to happen in the future, not necessarily what's happened in the past. During periods of large realized or historical volatility and a low VIX, investors expect the markets to calm down and trade more orderly. In periods of low realized or historical volatility and a high VIX, traders are worried about the future and expect large price swings in the index to occur more frequently.

Bear in mind, just because the VIX may be low, it doesn't mean volatility will not increase or vice versa. It is just a measurement for what traders and investors are anticipating. Like everyone else, they could be wrong. If the VIX is low, and you are anticipating a large price move in the future, it may be a good time to buy options either in place of, or in conjunction with, the underlying future. If the VIX is high, and you are interested in taking a position, it may not be the best time to buy options; rather you can construct positions selling options to help achieve your goal. In addition, you can also trade futures on the VIX either for outright speculation or as a tool to help hedge your options positions. However, when trading options and futures, especially when selling options, it is best to work with a professional. The risks are great, and they are not suitable for every investor.

Please feel free to call me at 877-847-3034 or contact me via email at mkrupski@lind-waldock.com if you have questions on this topic or to discuss specific trading strategies for your unique situation in this or other markets.

Learn more about VIX futures in "Trading VIX Futures, Lessons Learned so Far," a Lind-Waldock webinar with Jim Bittman. Sign up and view it free in our webinar archives.

You can also read a white paper from the CBOE that gives more information at the VIX, here.

Kristina Zurla Landgraf is editor of Lind eWire. She can be reached by email at editor@lind-waldock.com.

Futures trading involves substantial risk of loss and is not suitable for all investors.

Past performance is not necessarily indicative of future trading results. Trading advice is based on information taken from trade and statistical services and other sources which Lind-Waldock believes are reliable. We do not guarantee that such information is accurate or complete and it should not be relied upon as such. Trading advice reflects our good faith judgment at a specific time and is subject to change without notice. There is no guarantee that the advice we give will result in profitable trades. All trading decisions will be made by the account holder.

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