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The CBOE Volatility Index ($VIX) has become a popular subject in the media the last few years. The index is based on the S&P 500 index and estimates volatility by averaging the weighted prices of $SPX calls and puts. The media refers to the $VIX as the "fear gauge" of the market.

The $VIX typically runs inverse to the S&P 500 because volatility typically rises in a falling market and falls in a rising market. Compare the following chart:

Some of the important characteristics of the $VIX that are often overlooked include:

The $VIX is a volatility index that derives its value from various front-month call and put option prices on the S&P 500. Simply, the higher the option premiums investors are willing to pay, typically the more fearful they are that the markets will be volatile. This will lead to a rise in the $VIX.

$VIX futures and options can be traded but investors cannot trade the spot $VIX directly. $VIX futures trade on the Chicago Futures Exchange (CFE) and $VIX options trade on the Chicago Board Options Exchange (CBOE). This means if you purchase a $VIX options contract, you are not trading an underlying asset like with equity options.

$VIX options are based on the same month $VIX futures. May investors confuse this and assume that $VIX options are based on a spot $VIX index. This is not that case and is an important distinction to make. Therefore, at expiration $VIX options will settle at the same price of $VIX futures. So if $VIX futures settle at 20 at expiration, $VIX options will also settle at 20.

$VIX options are European-style options. This means that they can only be settled at expiration. Also, $VIX options are cash settled only so no assignment takes place at expiration.

The price of the $VIX represents the expected annualized standard deviation of the market. For example, if the $VIX is at 25, we can translate this as an expected 25% move either way over a year in the market. So if the S&P 500 is at 1,000 and the $VIX is at 25, investors expect the S&P to trade as low as 750 and as high as 1,250 over the next year.

While the relationship is there, it is certainly not perfectly correlated. The $VIX may act as a good short-term hedge, however it is not a reliable long-term hedge. Investors should be aware of the $VIX and its' levels because overall high market volatility leads to higher implied volatility in option premiums. Investment into the $VIX is not advised however.

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7.5- CBOE Volatility Index

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