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So you think you’re ready to trade the VIX through its futures, options, or ETFs. I’ve got news for you: most traders have no idea what they are looking at when it comes to anything to do with the VIX.
 
Since there is so much focus on the VIX as the “fear gauge” and because it is used as a fairly reliable sentiment indicator by traders, it helps to truly understand how it is calculated and what its fluctuations represent. 
 
First off, we need to know that volatility is simply good old standard deviation. And “vol” numbers like the VIX are expressed as annualized standard deviation. A VIX at 40 means that the market is expecting the S&P 500 to be within 40% up or down, one year from now, in about 68% of cases.
 
You might wonder how useful it is to talk about “where the market will be one year from now, 68% of the time.” I address that in my article Demystifying the VIX and show you a better way to think about this most-misunderstood barometer of risk using a special math “magic trick.”
 
Right now, let’s see how the VIX is constructed. 
 
While there can be volatility measures of the historical price movement of a stock or an index, the VIX is built from the “implied” vol of options prices on the S&P 500 index. 
 
Implied volatility tells you what the market “thinks” is going to be the actual volatility of the underlying instrument as seen through the prices being paid for its puts and calls. In this way, option prices “imply” the expected volatility. 
 
At the Chicago Board Options Exchange, owned by CBOE Holdings (CBOE – Analyst Report), the SPX is a real-time measure of the S&P 500 stock index. SPX options are traded off of that real-time calculation, though there is no actual trading of the index itself there. 
 
Big Money, Big Risk