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The VXN measures the implied volatility (i.e. estimated future volatility) of near-term at-the-money NDX options (click here for an excellent overview of options by the CBOE).  If the NDX moves significantly, new strike prices are used to calculate the VXN. 


Since there is a skew to options prices and implied volatility changes with the strikes, the VXN will typically rise when the NDX drops and fall when the market rises.  This is not always the case, but the correlation is clear.  In fact, the VXN has historically risen over 90% of the time when the NDX closes lower on the day.  When the NDX drops more than 3% on any particular day, there is a 99.5% chance that the VXN will rise. 


The common interpretation of VXN movements is that the VXN will rise when fear or uncertainty does, since there will be a greater demand for put options.  Conversely, when the market is rising, that typically creates complacency on the part of traders and the VXN will fall as the demand for put options decreases.



Instead of being focused on the absolute level of the VIX, we prefer to use Bollinger Bands to define our extremes, which shows us how extreme the VIX is compared to its average over the past quarter.  If the VIX goes outside of one of the bands, we know that it is two standard deviations away from its mean value of the past three months - truly an extreme event - any usually a precursor to a market reversal.

The following table lays out the criteria we use for the checkmarks on the Indicator page.


We also include a measure of the "volatility of volatility", which is a 21-day historical volatility of the VXN itself.  Looking at the data this way can often give us more accurate signals than watching the VXN, as it tells us how quick traders are to change their opinions of future volatility.


When they see no need to change their outlook, then we might assume that they are becoming complacent.  In that case, the historical volatility of the VXN will contract (i.e. the indicator on the bottom pane of the chart will exceed the red trading bands), and often a market decline will follow.



Chicago Board Options Exchange (www.cboe.com)


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