Trading the VIX to Hedge Stock Market Volatility

If you trade stocks, you may have heard the financial media talk about something called the VIX, also commonly referred to as the “fear index.” VIX stands for Market Volatility Index, and it represents how investors perceive volatility in the marketplace. The VIX tends to peak during times the stock market is falling or expected to fall sharply, and the VIX is typically at low levels during more stable or bullish markets, when investors aren’t too worried. When investors are worried, they will clamor to purchase options for protection, and options premium rises. You can trade futures on the VIX to speculate on potential movement in the S&P 500, or as a hedge for your equity portfolio during times of heightened volatility.

If you trade options, you probably know about the Black Scholes model of options pricing, which includes an estimate of volatility. The model’s limitation is that it must use an estimate for volatility in calculating the theoretical option premium, and that estimate may or may not bear out. The Chicago Board Options Exchange (CBOE), where most options in the U.S. are traded, developed a model to solve for the expected volatility using options prices in the S&P 100 and S&P 500. (more)