The Market Volatility Index

The Smart Profits Report: Issue #381
Friday, December 22, 2006

The Market Volatility Index: Using The VIX To Straddle And Strangle Stock Options
By Mark Whistler
Small-Cap Specialist, Mt. Vernon Research

Some of the savviest Wall Street investors turn to this gauge for market guidance. They use it to find out whether the overall trading mood is fearful or complacent.

But while many see this gauge as a very useful tool in determining whether to adopt a bullish or bearish stance, few actually understand what it means in relation to options.

I’m talking about the Market Volatility Index (VIX) - a measurement of two of the most important market sentiments: Fear and complacency in the market, as judged by S&P 500 stock index options.

And today, I’m going to “demystify” the VIX, so that it’ll become a useful tool in your trading repertoire, too.

Interpreting The Market Volatility Index Movement

First, it’s important to know that the VIX is traded as both futures and options on the Chicago Board Options Exchange (CBOE), and trades inversely to the markets. So when the market is going up, the VIX should be falling and vice-versa.

Simply put, here’s the basic equation:

When The VIX Is Falling: This implies that investors are complacent, and not worried about a market correction.

When The VIX Is Rising: This means investors are worried about a selloff, usually during times of economic concern.

Let me give you an example: In 1998, just before the infamous dotcom bomb, the Market Volatility Index was trading near 50 - an abnormally high level. As the VIX cooled off in the following years, the major indexes recovered from their lows. And right now, the VIX is trading near 20-year lows (just over 10), while the major stock indexes are trading close to 52-week highs.

When analyzing the Market Volatility Index, it’s important to look for “capitulation” points that indicate a looming trend reversal for the major indexes.

What you basically need to remember is this:

When the VIX gets too low, it means investors are almost overly-complacent, and the major indexes could be on the verge of a surprising and large selloff.

Conversely, when the VIX travels too high (in the 40-50 range), the index is telling us that investors are very fearful of market conditions, that stocks have declined substantially - and a short squeeze could be in the cards.

But there’s more to the story…

Paying Too Much For Stock Options? Check The VIX For Clues

The Market Volatility Index also lets us see whether options premiums will be cheap, or expensive. As a definition, volatility is a measurement of how rapidly stocks can fluctuate over a given period. And high volatility means more expensive options.

Again, here’s a quick guide to what you need to know:

When Volatility Is Low: This means investors do not believe stocks will fluctuate dramatically (i.e. they are complacent). Thus, options premiums should also be low.

When Volatility Is Elevated: Wall Street perceives a significant risk of large price swings, causing options premiums to become pricier.

Traders who sell options are pretty darn savvy bunch. If there is a greater risk that a stock will move through a strike price, they will demand more premium for the additional risk of writing the options.

What’s Happening In The Market Volatility Index Now?

The VIX is currently trading at $10.93 - a historically low reading by any measure. This is important for two reasons:

The VIX is trading near 20-year lows - a fact reflected in the massive stock market rally over the past few months. But for the indexes to continue moving higher, the VIX would have to break below 10, creating a “new paradigm” for the index, and a new range. While this certainly isn’t impossible, it’s fairly unlikely. Thus, those who patiently follow volatility closely, are more than likely waiting for the VIX to jump up before initiating fresh long positions in stocks.

After all, “When the VIX is in the sky, the bulls are looking to buy.” Why? Because in theory, when the Market Volatility Index is elevated, stocks should be cheaper. But right now, stocks are not discounted relative to the large run over the past few months. And again, for the major indexes to continue traveling higher (without taking a breather first), the VIX would have fall below 10 - something that’s probably not going to happen.

Many who covet volatility attentively are contending that at current “overly-complacent” levels, a sharp pullback is looming. And while this may be true, it’s almost impossible to predict the exact time when the selloff will commence. However, should the Market Volatility Index make a dramatic spike upwards, it’s probably a good idea to make sure all long stock positions are protected with trailing stop orders.

Using The VIX To Straddle And Strangle

When the Market Volatility Index is low, premiums should be low, too. And in the options world, low premiums are great for straddle and strangle positions. These techniques are best used when you’re unsure of which direction the market will take. Straddles and strangles can relieve you from having to choose the direction.

Here’s a refresher on straddles and strangles:

A straddle is buying calls and puts that have the same expiration month.

A strangle is buying calls and puts that have different expiration months.

However, straddles and strangles are not without risk. Low volatility also implies that the stock might not move at all, causing both puts and calls to expire worthless. In low volatility, sideways markets, time decay can be a killer.

In addition, even if the stock does move “in-the-money” on one side of the trade, if it only moves a small amount, the losing side of the trade can outweigh any gains from the winner. One way around this issue, however, is to find high-beta stocks, thus indicating greater volatility to the broader market.

Fear, Complacency, And The Dreaded Sideways Slide

Let’s wrap this up…

Essentially, the Market Volatility Index is a measurement of fear and complacency, but the index can also give us guidance as to whether option premiums will be higher or lower. What’s more, when the VIX is at extreme levels, it’s important to keep a close eye out for a reversal in the major indexes.

And finally, during periods of low volatility (like now), straddles and strangles can be an effective strategy - so long as the stock or market does not travel sideways.

In all, we see that the Market Volatility Index is not just a “guide to fear,” but it can also help clue us in to what type of option strategy might work well at that time.

Good investing,

Mark Whistler

Today’s Smart Profits Cribsheet

If you think market volatility always has to work against you… think again! Mt. Vernon Research Investment Director Karim Rahemtulla explains how and why market volatility is actually your friend when it comes to successful, profitable investing in Smart Profits #107, Market Volatility: How to Pay $27 for a $50 Stock.

In the issue above I mention the possible creation of a “new paradigm” within the Market Volatility Index. Investment Director Karim Rahemtulla offers a detailed options strategy for protecting your portfolio against a new investment paradigm that could pose a threat to your wealth in Smart Profits #375, Option Strategies: The Solution To The Most Dangerous Investment Paradigm Today.

Related Articles: