How to make money on volatility
With wild swings the norm for the stock market, the VIX offers a way to profit from fear and a hedge against market declines.
NEW YORK (Fortune) -- Wild swings have been the norm in the stock market lately - as you may have noticed - with the Dow Jones industrial average posting triple digit moves nearly every trading day since the beginning of the year.
The Dow made three-digit swings 55 times in the second half of 2007, vs. 23 times in the first half of the year. While such volatility is scary, there is a way you can profit from it. The key is the CBOE volatility index, known as the VIX (VIX). The VIX doesn't measure actual stock market volatility. Instead, it tracks trading in options on the S&P 500 to indicate how much investors expect the market to move over the next 30 days. As people expect bigger movements, options become more expensive. The VIX measures this price.
"It gives you an idea of how uneasy people are about the markets," says Joe Levin, vice president of product development at the CBOE, noting that a high value for the VIX generally means more market instability. "Some people call it the fear index," adds Levin.
Since the beginning of the year, the average index level has been 27, meaning that traders believe the S&P could change by 27% over a 12-month period, or about 8% over the next month. In 2007 the VIX average was 17 and in 2006 it was 13.
Moreover, volatility tends to increase as equities markets fall, so investing in the VIX can be a hedge against falling stock prices.
If you believe that the market will continue to gyrate madly, you can buy VIX call options (the right to buy) or puts (the right to sell), via an options trading account with a broker like Schwab, TD Ameritrade or Fidelity.
As with most options, Marty Kearney at the Options Institute says calls and puts on the VIX should be trading vehicles rather than long-term investments. You can also buy options on the Nasdaq Volatility Index (VXN) or on the Dow Jones Volatility Index (VXD), though the VIX index is the most actively traded and thus the most liquid.