VIX chart until May 18 , 2015
If the VIX was high, fear was rampant. And while everyone else was panicking, some thought the high VIX was an indication the market would bounce back. The CBOE Volatility Index® (VIX®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, VIX has been considered by many to be the world's premier barometer of investor sentiment and market volatility. Several investors expressed interest in trading instruments related to the market's expectation of future volatility, and so VIX futures were introduced in 2004, and VIX options were introduced in 2006. Options and futures on volatility indexes are available for investors who wish to explore the use of instruments that might have the potential to diversify portfolios in times of market stress. Maybe that’s true. Maybe not. There’s been a lot of chatter this year about whether the VIX can predict the direction of the market the VIX is just a weighted average of the out-of- the-money SPX options in the first two expirations, and then adjusted to mimic the volatility of an option with 30 days to expiration. Because it works off the actual bid/ask prices of those SPX options, it’s never “wrong.” It’s just a calculation. It is what it is. You can’t control where the market is going. Even picking direction is basically 50/50. But you can control the trading and investment strategy for your money. To me, the VIX is less of a market indicator and more of a strategy indicator. While less informed market participants and “talking heads” focus solely on the VIX as a number, many experienced traders aren’t put off by how high or low the VIX is. They watch it to make more informed decisions about strategy. As a trader, you have to stay a step ahead of the noise. Stocks, indices, commodities, indicators—they all go up, down, or both, every day. Analysts usually try to attach some news or reason to try to explain why the market did what it did. But that’s looking backwards. A trader has to be forward looking. And the VIX can help you with that. If the VIX is going up, it means the out-of-the-money option prices, which are used in the VIX calculation, are rising. What’s making them go higher? Mechanically, it’s because market participants—traders, investors, money managers, you, me—are trying to buy more of them. That buying pressure pushes up the prices of options, which, in turn, pushes up the VIX. Picture 1-2015 VIX Since February of 2015 VIX has been staying pretty constant between 12.5 % to 15 %, it means the out-of-the-money option prices aren’t moving much higher or lower which could mean there really isn’t any strong buying or selling pressure on them. You don’t have to know why, necessarily. Again, it just is what it is. Think about the VIX as a tool to make more informed strategies, rather than to predict market direction. Is it high or low relative to where it’s been for the past few weeks? What you’re trying to do is gauge the overall level of fear or complacency in the market, and how that’s impacting option values Since February 2015 the low VIX (12.5 % to 15 %) was an indication the market might be too complacent, overconfident and over-bought. A sell-off might be in the offing.
Bottom Line
As a trader, you have to stay a step ahead of the noise. Stocks, indices, commodities, indicators they all go up, down, or both, every day. Analysts usually try to attach some news or reason to try to explain why the market did what it did. But that’s looking backwards. A trader has to be forward looking.
1. IF THE VIX IS LOW, that’s an indication that market participants are a bit complacent-in 2015 12.5% to 15 %, and option premiums are relatively low, too. It doesn’t mean they’re undervalued. It just means there’s less extrinsic value in those options than there would be if the VIX were high. That makes some option strategies, such as covered calls, naked short puts, or short verticals, for example, less attractive because the lower option values means less credits taken in for those strategies, which decreases potential profits and increases potential risk. Strategies such as buying slightly in-the-money calls in further expirations as a stock replacement strategy can make sense, particularly if you sell nearer-term expiration out-of-the-money calls against them. It’s like a covered call strategy, but when you use the in-the-money call instead of long stock, you have lower capital requirements and lower risk if the stock drops sharply. Also, in a low-volume environment, the long calls have lower extrinsic value, making them less expensive and have lower risk. That’s a straightforward transition from a covered call, which is buying stock and selling an out-of-the-money call.
VIX 1 year Weekly Chart -June 30 2015
2. IF THE VIX IS HIGH, that’s an indication that there’s a lot of uncertainty in the market, with fear about what might happen in the near term future. Often, the VIX is higher when the market has sold off sharply. Instead of buying stock, you might consider shorting a naked put. This is a strategy some consider when the market or an individual stock has sold off and volatility, i.e. the VIX, is up. The reason is if the stock has hit a recent low, the put is going to have a greater value because the stock price is down and volatility is higher. When you sell an out-of-the-money put for a higher credit, your cost basis for the stock is lower if the stock price declines further and you’re assigned on the put. And that means your maximum loss is lower and your potential profit is higher. But what if the market moves up or down, and the VIX doesn’t change much at all? A trader might scan the rest of the market, from the SP 500 to the NASDAQ composite, bonds, gold, oil, the US dollar and bell-weather stocks. If, say, the market is down, but larger stocks are up, then the VIX could be indicating the market isn’t in “panic mode” quite yet. Alternatively, if the equities in general are up and you expect the VIX to be lower and it’s not, that might indicate growing fear and uncertainty in some of the market participants who are still buying those out-of-the-money options as protection. THE POINT IS THAT YOU DON’T HAVE TO BE an expert option trader to use the VIX. Even novice investors who are getting started with options can use it to help make simple adjustments to their strategy that can potentially work to their advantage. The VIX is simply a tool. Whether it’s good or bad for your trading depends on how you interpret it. It is what it is.
VIX 9 months Daily chart until June 29 , 2015- Dow Jones Industrial drooped 350 points on that day
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