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Volatility: The difference between implied and realized

With the Fed’s QE3 kaput and their continued pledge to keep interest rates near zero for a “considerable time” has many investors betting volatility will subside and markets will normalize. 

The Vix is still well below its average of about 20. What does it mean and can you trade it?

This is also known as implied volatility or more simply what the market is expecting. This is evident in the  CBOE Volatility Index (^VIX) which has dropped to the 15 level down from the October highs of 31.

However, Jeff Kilburg, founder and CEO, of KKM Financial, cautions that the VIX doesn't tell the whole volatility story. “To see the implied volatility lower than realized volatility, that is a flip flop from August, so I think it is important to understand people are not expecting a big move and when people are not expecting that type of move that’s where complacency comes into the market.”

Realized volatility, as Kilburg explains, is more tangible because it is the actual daily movement of the S&P 500 Index (^GSPC) either up or down, a realized gain or loss. In order for investors to become less complacent, Kilburg would prefer to see a higher VIX. “You want that volatility to come back and normalcy, the average or mean for the VIX is 20, so here we are back under 20 not quite where we need to be.”

Now that the Fed has confirmed the removal of the latest round of QE stimulus the market will likely rely more on fundamental news and valuations which may jolt volatility higher.

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