Volatility Could Be Your Friend
Whenever the stock market has a particularly bad day or when it’s in a bad stretch, you will often hear the news talk about the “Fear Index,” aka VIX, jumping as an indication that investor fear is rising.
VIX itself is actually also just a nickname. The formal name for the index is the CBOE Volatility Index. (CBOE in turn stands for Chicago Board Options Exchange, the largest options exchange in the world.) The index takes the weighted prices of call and put options on the S&P 500 and calculates implied market volatility for the next 30 days.
The calculation itself is too complex to try to explain here. Thankfully the CBOE does all the work and publishes the VIX values. A simple interpretation of the VIX is that when option buyers are willing to pay a higher premiums for options, it means the market overall expects higher volatility—i.e., bigger ups and downs.
A Gauge of Angst
The lower the reading, the calmer the market. A very low VIX reading could actually be a contrarian bearish signal. This makes sense because if most market participants feel complacent, it’s easier for a negative surprise to shock the market. On the other hand, if market participants expect bad news, then negative expectations are already largely baked in, so it’s harder to further surprise them on the downside.
As of this writing, the VIX is right around 13. A reading under 20 is considered to reflect a calm market. The higher the reading goes, the most nervous and unsettled the market is. For context, the highest the VIX has ever reached was 83, during March 2020 as Covid lockdowns were announced. During the height of the Financial Crisis in 2008, it reached almost 81.
During those times, uncertainty was sky high because the market was facing extreme scenarios it hadn’t faced before. When uncertainty is high, that’s when stocks tend to fall the most. Even if there is very bad news, at least the bad news is known and investors can apply a discount as they see fit. But when no one knows what to expect, often investors sell first and ask questions later.
Volatility and Options
As mentioned earlier, the price of options are key inputs into the VIX. When you buy an option, volatility is your friend. If the underlying stock hardly moves, you are likely going to lose money on your trade even if you are correct about the general direction of the stock.
Let’s say you buy a $38 call on a $35 stock and the stock makes it to as high as $37. If the stock had made an up move as soon as you bought the option, you might have been able to sell at a profit, but if you had held onto the option, chances are you will end up with a loss.
Notice that even if the stock fell to $25 at option expiration, your call would still be worth the same as if the stock had been $37—i.e., out of the money and worth nothing at expiration. Thus, when you are long an option, you want significant price movement.
Make Money in Down Market
In the case of puts, investors can buy puts to protect stocks they own to guarantee that they can sell the stocks at no lower than the strike price of the put options. Additionally, they can also speculate on a downward movement in the stock. Indeed, buying puts is one of the main ways to make money even when the market falls.
When buying a put, the maximum you could lose is the amount you pay for the premium. Compared to shorting, where it’s possible to lose more than 100% if the market moves against you, buying a put is less risky. Indeed, if caught in a short squeeze, a short trader’s losses can snowball.
You could even use the VIX as a guide to help you decide when you make your option trade. For example, if you think the VIX is too low, it may be a good time to buy a put. On the other hand, if you think the index is too high, it may be time to write an option.
Editor’s Note: if you’re nervous about mounting market risks, I suggest you consider the advice of our colleague, Jim Pearce.
Jim Pearce is chief investment strategist of our premium service Mayhem Trader. He has spent the past year perfecting a powerful indicator that’s designed to make money in a hostile market.
Jim has a proven knack for reaping profits from Wall Street chaos. To learn more, click here.