VIX Index: What’s that about?
Today's Financial News - Posted October 23, 2008
The financial headlines are more complicated than ever. Investors are being forced to digest some very complicated concepts. Here’s some help that will make you money?
By Andrew Snyder
Baltimore – (TFN): This is one of the most unique times in Wall Street’s storied history. With the nation facing a financial crisis like it has never seen before, it is no wonder we are hearing of theories and measurements that are unfamiliar to so many investors.
Notions like default swaps, mortgage-backed securities, TED spreads, commercial paper and the VIX are some of the most important terms on Wall Street right now, yet few everyday investors know much about them.
Over the next week or so, I will do my best to explain the critical concepts. If you want to be a successful investor, you have to know the lingo and how in the world it all relates to you.
With the so-called VIX making its way into mainstream headlines and shattering its old records, I say we start with it.
Back to school
The “VIX” is technically nothing more than the ticker symbol for the Chicago Board Options Exchange Volatility Index, which was designed to measure the implied volatility of S&P 500 options.
Still confused? Don’t be. It is all pretty simple.
Some folks call the VIX a measure of market “fear.” But I like to think of it more as a trading range predictor.
It helps to imagine the VIX in terms of percentage points. The figure roughly represents the range the market feels the S&P 500 will trade within over the next year.
During typical market conditions (not what we are seeing today), the average VIX reading is about 26. On a 30-day basis, that leads to a predicted movement of 7.5%. That figure makes sense as we often see wide jumps in the S&P 500.
But what about today’s reading of over 76.69? Obviously, it means the options market is expecting a lot of volatility. But how much?
Well, if we divide today’s reading by the square root of twelve (to show movement on a monthly basis), it gives us a reading of 22.14, meaning we can expect a trading range of over 20% in the next month. On a daily basis, it means swings of over 4%.
That, too, makes sense. After all, we have seen the S&P 500 drop by over 25% in the last month and the markets are making 3% to 5% daily moves.
Another important lesson
But there is something much more important this volatility index can tell investors. It is an indicator far too few folks take advantage of.
The VIX can give us a virtual x-ray of the options market. With a reading in sky-high territory, I know that options spreads across the entire market are quite large and options profits are fairly limited.
It also tells me to take a fairly conservative approach to options investing. When contracts are selling for a premium, it takes larger swings in underlying share price to get options moving.
That is why I tend to stick with in-the-money contracts that move in step with share price, just as HotStockConfidential.com traders did last week to grab gains of over 85%.
With the markets moving by large leaps, this strategy will provide you with the profit potential normally reserved for fairly skeptical options plays. Best of all, it does it with much less risk.
Lots of opportunities
The options market is as tight as it has ever been and the VIX proves it. Investors are fleeing to options in record numbers in a last-minute effort to hedge their portfolios or make back some of the money they have lost.
When the equities market first started these wild intra-day swings, the VIX was dramatically lower and options were much, much cheaper. The profit potential from options was off the chart.
Now that the VIX is much higher, it is an indication that the options market has tightened. It still offers some great profit potential, but you have to do your homework.
Keep an eye on the VIX and you will get a near-perfect indication of what is happening deep inside the options market.
Next Article: Apex Silver (SIL) shares are falling… for 20%-plus in short gains for TFN readers
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