The CBOE Volatility Index, or VIX, measures the implied volatility of the SPX options. Let’s rephrase that: The VIX measures how cheap or expensive options that can be used to hedge broad-based portfolios are. Let’s rephrase that once again: The VIX measures how scared investors are.
There is a normal ebb and flow for the cost of insurance, in terms of options prices. Over the past six months, the VIX has been in a range between about 16 and 22. But, On Wednesday, March 16, the VIX shot up to hit a high of 31.28. And fell right back down nearing its six-month range on Friday, closing at 24.44. These rapid rises and falls in the VIX, are referred to as volatility spikes because they look like, well, spikes on a price chart.
Why the volatility spike? Panic in the streets. Japan, the Middle East, the homeland… For a brief moment, emotionally charged traders snapped up options to hedge or speculate driving up options prices—i.e., implied volatility—with the ferocity of a leopard about to enjoy some impala tartare. And, then, that was it. Back down to Earth for traders’ fears and consequently the VIX.
The "Smart Money"
So, what did the smart money do? They sold it. The VIX is a veritable asset in and of itself. Traders can trade the VIX by taking a position in SPX options, by trading VIX futures or trading VIX options. The thing about implied volatility is that is tends to revert to its mean. Volatility spikes are just that—spikes: a quick move up followed by just as quick a move down.
Though there have been a few periods in recent history in which the VIX has resided above 30 for a short period of time. It doesn’t tend to remain that high for long. Experienced traders get a metaphorical nosebleed when the VIX is that high. They seize the opportunity by getting short an asset that is likely to return to its normal confines, like a rubber band being stretched too far. Again, these spikes tend to not last long. When opportunity knocks, good traders answer, and fast.