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Steve Smith explains what the VIX truly is and how to trade it.

My guest today is Steve Smith and we're talking about misconceptions about the VIX.  Everybody watches the VIX these days to see what's going on with the market, but what misconception myths are there about this.  So Steve, VIX is it well understood, misunderstood, what do you think?

I think it's not understood and one of the biggest misconceptions that it's an asset class.  It's really not, it's a statistic and it tends to revert to the mean.  One of the reasons that I think the misconception came about was about in 2005 you had the CBOE, which nothing against them, I was a member of the Chicago Board of Options Exchange as they launched futures on the VIX and we've seen a lot of products come out of that. 

So people think that they can look at it, both whether it's from technical analysis or from an absolute price level and it's not; it reverts to the mean.  So just to go on, I mean most recently you've seen in August, you have to compare it on a relative level to the historical or realized volatility.  So in August, you had the VIX at 16 or so and everyone was like wow, that's so low, we're heading for September, there's going to be a crash because everyone is complacent. 

The reality was that in August, the realized or historical volatility was about 10.  So there was a huge premium.  It was six points or 60% premium in the VIX.  Now you've seen as we've pass through Jackson Hole, Fed meeting, variety, the ECB that they've converged.  Now you have both the VIX and the realized or historical volatility are both trading around 14.

So what it is the right way to kind of use the VIX as a tool as a trader then?

To be honest with you, I really wouldn't trade any of the VIX products.  I mean I'm an options trader.  I was a market maker like I said on the floor.  If you think volatility is going up, I would go right into because it is based on the S&P options.  Go and buy a straddle.  Don't go into this TVX or these inverse or double-leveraged products because you don't know how they're going to perform unless you're very sophisticated.  It's not an asset class.

All right, how about a straddle?  Talk about that, give me kind of an example of the straddle.

Well, again you could look at just very recent history.  The market ended up, we've melted up in the last few days.  All right?  After Ben Bernanke came in with his QE3 and realized the actual volatility rose because everyone thinks that volatility goes up when the market goes down.  It's not a direction dependence statistic.  It's actually just based on movement, up or down.  Back in the tech bubble, we actually had really high volatility when everything was going up because people were reaching for calls. 

More recently obviously people have reached for puts so it tends to be associated with the decline in the market.  So that's why I would just go and look at, if you think like right now there's no premium of the VIX to the realized volatility.  If the S&P is trading around 14.40 right now, go and buy that straddle on the assumption that it will continue to move higher.

Define a straddle for me.

It is you buy both puts and calls with the same strike or a strangle is you buy them with slightly out of the money strikes.

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