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The VIX and VXO
The Smart Profits Report: Issue #402
Thursday, March 8, 2007
The VIX and VXO: How You Could Have Predicted The Market’s Recent Meltdown
By Lee Lowell
Futures Options & Commodities Specialist, Mt. Vernon Research
Well, it finally happened… After a 7-month rally that saw the stock market shoot up without stopping for breath, it was inevitable that the continual upmove would produce the thrashing that we’ve seen over the past week or so. Investors were asking for it.
Why do I say that? Simply put, it’s because investors were so complacent. They got so used to the market rising, they expected it to just continue heading up in a straight line. But that never happens without some kind of big reversal. And if you follow this key gauge, you could have predicted the move. I’m talking about the two volatility indexes - the VIX and VXO. So let’s dig into these revealing indicators…
Follow The Volatility… Gain An Advantage
Want to know why options traders often have a forecasting advantage over their stock investing counterparts? Because they follow these two indexes closely, since volatility has a direct effect on options prices.
But here’s the thing: Even if you’re not a regular options trader, you can still easily track these indicators, so you have an idea of where the market could be headed next.
Simply put, the VIX measures the volatility of the options that comprise the S&P 500, and the VXO measures the volatility of the options that comprise the S&P 100.
And when we got a spike higher on both these indexes, it meant the markets were finally making a large move. That’s because when the VIX or VXO spikes upward, that’s usually an indication of the stock market dropping in price.
But that’s not all these indexes show us…
Watching the VIX or VXO: From Calm Complacency To Ferocious Fear
Not only does a spike in the VIX or VXO mean that the market is moving, but it also means options prices are getting more expensive as well. This is because volatility is one of six factors that determine an option’s price, and plays a major role in the market.
If you look at the chart of the VXO below, you’ll see how it channeled along at a very low level for months and months. That was an indication that investors felt very comfortable with the market and that big moves were not in the cards.
But just look at the huge spike upwards over the last few sessions. That was a direct response to the downside plunge in the stock market - and subsequent fear it created.
If you’re an option seller, you need spikes like this, which inflate the prices of the option you want to sell.
If you are an option buyer, volatility spikes will cause your long option to gain in value too.
So increasing volatility is usually good for everyone. I say “usually” only because if you sold options while the VXO was in the 10% range, then your options probably spiked higher against you temporarily. Now that the market is currently retracing some of its downmove, the VXO has retraced as well, bringing option prices down with it.
So exactly how does volatility impact option prices so directly? Let me show you…
How Volatility Has A Direct Impact On Option Prices
Take a look at the two charts below, showing a typical option calculator.
In the first example, we’ve priced out the theoretical value for the at-the-money April 2007 OEX 640 strike calls and puts. We’ve inserted 10% volatility on the left-hand side. The value for the call and put are on the right-hand side at $9.11 and $8.75 respectively.
But let’s see what happens when we bump up the volatility to more current levels at 14%.
The volatility input on the left-hand side is the only number we’ve changed. But look how the option prices have increased to $12.63 and $12.26 respectively. Having left all the other inputs unchanged, the only reason for the spike in option prices is due to the change in volatility.
So why is this volatility change so important?
Volatility Is Your Friend When Using the VXO
Simply put, as active option traders, our decisions are based on where volatility is currently trading compared to its past history. With the VXO trading at the 10% level, that meant option prices were the cheapest they’ve been since the VXO was established.
So if you were trying to sell options at that point, you were taking a very big risk that volatility could spike higher on you at any moment.
Personally, I like to check to see where volatility is on an historical basis so I know whether I’m going to be buying or selling options when volatility is cheap or expensive, based on its past levels. Then I’ll try to tailor my option strategies to wherever volatility is at that time.
News Breeds Volatility: Key Events That Can Vault The Volatility
Usually, volatility doesn’t just appear from nowhere. And just by keeping an eye on key events, you can project when it might rear its head and have an effect on option prices.
For example, if you’re an options trader, watch the market during the days leading up to quarterly earnings reports. You’ll often find that uncertainty over what a company will say will lead to option prices spiking temporarily until the report is released. This is due to the option market-makers protecting themselves in case the announcement has a major impact on the stock price.
Once the report has been made public, the option prices will have the air taken out of them and return to more normal levels. So don’t be surprised if that call option you bought before earnings actually goes down in price - even though the stock may be trading higher after earnings are released. This is due to the fact that the drop in volatility has overpowered any effect that a positive move in the stock has contributed to that option price.
My advice here is to keep an eye on volatility, using the VIX or VXO, on an historical basis so you’ll know whether you’re buying or selling options at a period of high volatility or at a period of low volatility. And there’s an easy way to check on the volatility of any stock you like. Simply go to http://www.ivolatility.com.
Good trading,
Lee Lowell
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Today’s Smart Profits Cribsheet
- Simply put, volatility indicators measure the two most important market sentiments: Fear and greed. Here’s the basic equation: When volatility is falling: It implies that investors are complacent and not too concerned about a market correction. This is what we saw before the big selloff at the end of February. When volatility is rising: This suggests investors are fearful about a selloff. The first chart in today’s message demonstrates this perfectly.
- Just a few hours ago, Lee wrapped up an interview with Matt Krantz for Friday’s edition of USA Today. Be sure to check it out tomorrow. As a Smart Profits Report reader, you can also read what Lee has to say in his new book Get Rich With Options: Four Winning Strategies Straight From The Exchange Floor. Visit this page for more information.
- Volatility doesn’t have to wield a negative impact on your investments. If you pay attention to volatility indicators, as well as news that can drive stocks higher or lower, you can use it to very profitable advantage. At the Xcelerated Profits Report, we recently benefited from “positive volatility” in a major way when a groundbreaking small-cap stock in our portfolio released news that immediately makes it the leading player in an industry that we believe will form one of the next technological revolutions. To find out more, visit this link to read our special report.
Related Articles:
- The VIX Index: Instant Access to the World’s “Best Contrarian Indicator”
- The Market Volatility Index: Using The VIX To Straddle And Strangle Stock Options
- Market Volatility: How to Pay $27 For A $50 Stock
