The field of investing is centered on expected risk and return. This week Amazon.com, Inc. released its second quarter earnings report which revealed a 45% increase in earnings driven by a 41% increase in sales, yet the share price dropped 13% on this news in after-hours trading. Though Amazon reported an increase in earnings, this increase was not high enough to match investors’ expectations which were built in to the intrinsic value of the securities. Thus a lower than expected earnings report, though positive, resulted in a sell off and price drop.

I’m still trying to figure out how to blog about what interests me, but I can already tell that there is no value added by regurgitating major market news that has already been dissected and analyzed by news corporations. This post will instead be didactic: I’ll touch on some market news while introducing an instrument that measures investors’ perception of market risk: the Volatility Index (VIX). The VIX measures the implied annualized volatility of the S&P 500 for the next 30 days.

Today Bloomberg reports that the VIX closed at 28.79. Using that number I can calculate that the perceived daily volatility by dividing 28.79 by the square root of 252 (approximate number of trading days in a year) and the perceived monthly volatility by dividing 28.79 by the square root of 12 (number of months in a year). I find the monthly to be 8.31%. This is the expected standard deviation; if the expected monthly return on the S&P is 3%, investors anticipate that there is a 67% chance (“it is reasonable to assume”) that the S&P will move between 11.31% (3%+8.31%) and -5.31% (3%-8.31%) of its current value in the next month. Another way of thinking of this is as the expected risk of being invested in the S&P for the next 30 days.

The market’s adjustment to information is very efficient. On the graph of the VIX above, major fluctuations correspond to major events in financial news. The spikes in May occurred because of the Greek debt crisis and the sudden loss of confidence in the European Union’s ability to hold itself together financially. The VIX rose this week, not so much because of disappointment over a single company like Amazon, but because of the financial regulation bill said to be “the most sweeping overhaul of U.S. financial-market regulations since the Great Depression.” Several aspects of the bill, such as the refusal to bail companies out in the future, increase the risk of losing an investment in the market, which hikes up in the VIX.

So how does one profit off of the VIX? There are infinite strategies to act on the VIX, directly and indirectly. Investment vehicles include VIX ETFs, options, and futures contracts. One might collar other investments when the VIX is high, and sell covered calls when it is low. The market is not perfectly efficient, so there is an opportunity to capitalize on overreactions (more on market efficiency later). Keep in mind that wild fluctuations make investing directly in the VIX is a short term strategy.

Note: writing about investing is challenging, not because the field is particularly difficult to understand (quite the opposite, actually), but because of the varying levels of experience in the readership. If this post was a review, look forward to some more advanced techniques like hedge fund return replication, CVaR-based portfolio optimization, fundamental analysis techniques, and maybe investment ideas to capitalize on major news in future posts. If this post went over your head, fear not! I’ll likely do a brief introduction to investments in a future post which will bring you up to speed.