Carpenters have a level. Investors have the VIX
Today's Financial News - Posted June 8, 2009
Successful investors use all the tools they have available to them. For options traders, one of the most important indicators is the VIX. It is bouncing off of recent lows, but is still in historically high territory.
By Andrew Snyder, TodaysFinancialNews.com
Baltimore – (TFN): Is thirty the new 15? Is what was once considered outlandish the new norm?
No, I am not talking about the latest women’s fashion trends or anything else you would ever hear on Oprah. Instead, I am pondering the VIX (a.k.a the CBOE Volatility Index). Just a year ago, today’s levels would set off alarm bells. These days, the VIX at 30 is a cause for a sigh of relief.
Is it the start of a new trend or is it proof we are still in dangerous territory?
I’ll take the latter, if you please.
Since reaching its peak near 90 in November, the index has recently dropped to what many investors are viewing as a new bottom. Two years ago, today’s levels were reached only when something major was shaking the markets.
After 9/11, the index climbed to just 43. But after a few more days like today (up by more than 5%), we could be at that level by the end of the week.
To figure out what is going on and how to profit from it, we have to review what the VIX is telling us. If you recall, the index is designed to measure the spread between put and call options contracts trading on the S&P 500 index.
The wider the margin between the contracts, the higher the VIX.
More specifically, the VIX measures the implied volatility of the options. It tells us how far investors realistically believe the markets will move.
A mathematical crystal ball
While the math is a little rough, we can use the VIX to determine what kind of action the market is expecting (or hedging against) over the next 30 days or so.
If we think of the VIX in terms of percentage points – the current reading is 30.7% – we can figure the market has priced in a move of an annualized 30.7% rise or fall. In a month, it would equal a move of about 8.86%.
That’s a pretty big move.
Will it happen?
To answer that, let’s look at recent history. When the VIX hit 90 in November, it was predicting a drop of about 26% in the next month. In the next thirty days, it jumped by 18%.
Close, but not perfect.
If we look at the recent market action, a dip or a surge of 8%, while drastic, would not be too far out of the ordinary.
The question for options investors is does the markets have it right?
It you believe the S&P 500 is going to stagnate in its current range for the next month or so, you should be selling options, banking the premium and hoping your prediction is true.
If, on the other hand, you believe the markets have got it all wrong and the markets are going to make an even bigger move in either direction, you should be buying all the options you can afford.
If your bet pays off, you could be sitting on handsome gains.
Unfortunately, there is no index to tell us who is right and who is wrong. That is where education, experience and the ability to decipher the news becomes an asset.
As an options trader, the ability to interpret volatility and what it means is the key to success. The VIX is one of my favorite and most trusted tools.
Carpenters have a level and a square. Investors have the VIX.
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June 8th, 2009 at 12:54 pm
I was interested in your analogy that “Carpenters have a level and investors have the VIX.” Thought you might also be interested in a very information piece that CBOE just did, entitled “VIX: Fact and Fiction,” given that many have become a bit confused on what the CBOE Volatility Index (VIX) really measures. It’s a pretty simple piece that investors of all stripes should avail themselves of: http://www.cboe.com/publish/ResearchNotes/Research_notes_5-1-09_Issue_2.pdf