Many traders, both novice and professional, like to opine on the current levels of the VIX, the CBOE Volatility Index, as signaling extreme market complacency and thus the cue for a market decline of some magnitude.

Unfortunately, the VIX is a sufficiently complicated mathematical animal that most of those offering opinions don't really know what they are talking about. After you read this "must-know" stuff about the VIX, you will know more than most of them and be able to slice through or simply ignore their nonsense.

*1) Standard Deviation:* Volatility for options traders is always expressed as annualized standard deviation. That means a VIX of 12 says that "the market" (S&P 500 options traders and institutional equity hedgers) expects the index (SPX.V) to be within 12% higher or lower, one year from now, in about 68% of cases. In short, it is a probability estimate.

*2) Implied Volatility:* The VIX is constructed from the "implied" volatility of SPX near-term options traded at the CBOE. Implied volatility is produced by running the Black-Scholes options pricing model backwards by inputting an options price to see what volatility it "implies" instead of inputting an expected volatility to see what a fair value price for the option should be.

*3) The Price of Risk:* Volatility for options market makers and institutional hedgers is the price of risk, much like insurance. The SPX option market makers are "dealers in insurance." The market makers hedge their risk with institutional cash index baskets, futures, and/or other options. They want to profit from buying perceived low volatility and selling perceived high volatility. But their time frames are short-term, from hours to a couple of months.

*4) Market Maker Business:* To convert the VIX to a daily volatility number, simply divide by 16%. For example, a VIX of 12% divided by 16% = 0.75%. This means that the VIX is "pricing" about 0.75% daily volatility. A VIX of 16 would imply 1% daily volatility. This is roughly true because "vol" is proportional to the square root of time and 16 is the approximate square root of the number of trading days in a year.

This is important because option market makers have to price and hedge SPX options on an hourly, daily, and weekly basis in a very competitive business environment. The VIX therefore reflects not only institutional expectations about volatility and risk over the next 1-4 weeks, but also the market makers' daily business risk-and-reward estimates.

*5) A VIX of 10 is Normal Now:* 30-day historical volatility for the SPX just dropped to 7% in this quiet market. That implies daily volatility of under 0.45%. A VIX of 11 implies daily vol of about 0.7%. The VIX probably won't go to 7 as its function is pricing the anticipated risk of the coming 30 days, but I wouldn't be surprised if it creeps down to 9 as equity markets quietly grind higher.

*6) VIX Doesn't Trend, It Drifts & Jumps:* My final sin of VIX bloviators is when they try to tell you that the chart is forecasting a certain move. Anybody who puts moving averages, patterns, and other technical analysis on the VIX truly doesn't understand it as a fluid function that mathematicians call a "stochastic" process. When the VIX isn't jumping to re-price risk, it is drifting, decaying, being bought and sold in relationship to the underlying actual volatility of the SPX index.

*7) VIX-Based ETPs Are Dangerous:* Because the VIX is such an unique mathematical function -- and not a conventional security like a stock, bond, or commodity whose price is based on market perceptions of value (and which can theoretically go to zero or infinity) -- its derivatives can be even more slippery to understand and make use of. Here's the gist of what I told one trader recently on StockTwits who was trying to make predictions about the S&P 500 index based on the price movements of VXX, the iPath S&P 500 VIX Short-Term Futures ETN:

"Since you are suggesting that a derivative (VXX) of a derivative (VIX futures) of a derivative (:VIX) should have strong predictive power about the S&P 500, you have proven you do not understand options volatility, the VIX, futures, ETPs or nearly all derivatives."

The leveraged ETPs like UVXY and TVIX are even more dysfunctional products as they are perpetual victims of VIX futures "contango" (Google it) that should be banned by the SEC. XIV and SVXY, the ETPs that short volatility, may still be very useful, though not without some risk just like any derivatives.

*Who Am I to Say?*

What are my qualifications for offering such criticism and advice about volatility "speculators?" Though I was not an option professional myself, I learned from some of the best option market makers in the world at the CME and the CBOE from 1994 to 2010.

Many of them had roots going back to the formation of standardized option markets in the early 1970s and they knew either Fischer Black, Myron Scholes, or Robert Merton. Some even wrote practical handbooks for option professionals, like Shelly Natenburg, my first real-world classroom teacher on these subjects.

If you really want to understand "Option Volatility and Pricing," then pick up his book on Amazon. It will teach you everything you need to know -- short of having a pro teach you in the real world.

Next time, I'll discuss the limitations of volatility -- i.e., standard deviation -- in adequately measuring the risks in financial markets. That subject is covered well in Nassim Taleb's 2007 book "The Black Swan," which was published before the VIX even imagined it could go to 80 in the 2008 crisis.

Bottom line: Unless your friends are option market makers, beware friendly advice about volatility.

Your VIX advisor,

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