VIX Explained. Be smarter than your friends!

Having a basic understanding of the Chicago Board of Exchange's (CBOE) measurement for stock market volatility, known as the VIX, is a great tool for any investors toolbox. Even if you're not a professional contractor, its useful to know how to use a hammer. So think of the VIX as the hammer of your investing toolbox, you may not use it everyday, but when something breaks at least you'll know what it is. Now prepare to be smarted!

Quick definitions (for beginners):

1. S&P 500 Index - a group of 500 of the most popular stocks lumped together. Most people own some form of the S&P index, or the stocks comprising the index, in their retirement accounts or portfolios.

2. Options - "calls" and "puts". The right to buy or sell stocks at a pre-determined price during a set time period. Kind of like insurance on stocks. Once the strike price and expiration date are set, option prices are determined by volatility. More volatility, higher prices.

Lets get started: The VIX is a proprietary measure of the volatility of the S&P 500 index published by the CBOE. It basically measures how much price movement, up or down, people think stocks in the S&P index will have over the next 30 days. So its not a measure of how much stocks moved yesterday, its a measure of how much people expect stock prices to move in the future.

The actual formula and technical definition of the VIX is mildly complicated and not all that important to understanding the concept of the VIX itself, so for now we're going to ignore the technical stuff. The VIX gets (or derives) its value from the prices investors pay for options on the S&P 500 index. If you think of options as insurance on your portfolio, the more uncertainty and concern there is over the occurrence of an event having a negative impact on an assets price, the more willing someone will be to pay for insurance against that event. For example, If you're house has been hit by 5 tornadoes this year, you'll probably be willing to pay a hefty premium for future tornado insurance. On the other hand if your house hasn't seen a tornado in 20 years, you're much less likely to put the same value on that policy. The options market works the same way, repricing "premiums" throughout the day. Big swings in stock prices lead to higher options prices and in turn higher VIX numbers.

The cool thing about the VIX, and volatility in general, is that you can buy or sell those premiums. You can be the insurance company or the insurance buyer. Referring back to the example above, if you don't think there will be any tornadoes for the rest of the year, you might be happy to sell an insurance policy to the guy who just got hit by 5 tornadoes, collect the premiums from selling that policy, and let the policy expire.

The last thing you have to know is what the actual number associated with the VIX means. If somebody says, "Hey smart friend, the VIX is at 16 this morning, what does that mean?", you need to have an answer. The technical explanation is that it's a measure of the "standard deviation" of price movement in the S&P 500 index. For our purposes, we're going to make an interpretation of that answer which is much, much simpler. Again, if we think of the VIX as a measure of how much price movement, up or down, we expect for stocks, all we have to do is convert that VIX number to a percentage to make it super easy to understand.

Now this is a rough estimate, but a VIX number of between 16-18 equates to an approximate expected move of 1% daily. So if the S&P index is at 2000, and the VIX is at 17, investors are expecting the market to move 20 points (up or down) on a daily basis for the next 30 days and are pricing options (portfolio insurance) based on those expectations. If the VIX is around 30 investors are pricing in an approximate 2% daily move. If the VIX is over 20 that's usually an indication that investors are getting nervous and paying up for insurance. Under 15, and people are generally not concerned about adverse market movements.

Very important to remember: A low VIX number does not mean market stability, it only means investors think the market will be stable. Similarly a high VIX doesn't mean the world is collapsing, only that investors think the world may collapse.

So don't wait to until your house is on fire to buy insurance. Buy it when its cheap and sell it when its expensive. Happy trading, and I hope you feel a little bit smarter than when you started.

About the Author:

Mr. Kafin is the managing member of the K-FIN Group at Sotheby's International Realty. The K-FIN Group specializes in real estate transactions for alternative asset professionals. He is a member of the CFA Society for financial analysts, and was both a derivatives market maker and general partner for two Private Equity ventures.

If you’d like to chat about South Florida real estate or any of the topics discussed in this article please feel free to contact me. I live on the Miami Beach and would love to chat. Hope to talk to you soon!

Sam Kafin

(T) 954-821-5441 email: sam@kfingroup.com