VIX

In the early ‘80s, when I was running a hedge fund from the floor of the Chicago Board of Options Exchange (CBOE), I was a market maker in OEX options. The OEX is the Standard & Poor's 100 Index. The CBOE Market Volatility Index (VIX) was born from trading options on the OEX and from our desire to more accurately price risk.

The stock market volatility index (VIX) - or "fear gauge," as it's often called - has been giving off unexpectedly low readings in 2011.

But don't be fooled. Things aren't what they seem.

Structural dynamics are currently suppressing the VIX, and are diminishing its predictive power.

If you want to trade this as a speculative investment - or even if you just want to use the VIX to better hedge your portfolio holdings - you need to understand the forces that are working on this stock market volatility index.

Let me explain ...

I Was There for the Birth of the VIX

Back during my hedge-fund days, we used Monchik-Weber machines with their built-in Black-Scholes options pricing formula to help us mathematically measure put and call-option values. The computers would provide us with the theoretical value of the options we were trading.

But it wasn't long before a gap between those theoretical values and the actual market prices drove us to find a different way to measure volatility. To calculate "implied volatility" - the estimated volatility extracted directly from bids, offers and actual prices - we looked at real-time prices as opposed to theory.

Simply put, based on actual prices for calls and puts on the OEX, we separated out implied volatility and used it as a measure of what traders were expecting to happen.

This volatility measure is the expectation of price movement over the next 30 days. The higher the reading, the more likely stocks are to move in one direction or another.

Over time, our volatility index became known as the VIX. And eventually, the VIX - not the OEX - became a measure of options-pricing volatility based on the Standard & Poor's 500 Index.

The VIX is called the "fear gauge" for a good reason: As that index rises, it's basically telling us that traders and investors are paying a greater premium to buy options, mostly because they are "paying up" to buy puts.