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Vix Volatility – a deeper look into a complacent market

Today's Financial News - Posted January 6, 2010

Investment U’s resident options contributor, Karim Rahemtulla, expands his lesson on analyzing the CBOE Volatility Index and using it to guide profitable options trades.

Karim Rahemtulla (Investment U):

The stock market kicked off 2010 with a bang, as the major indexes used strong manufacturing data to scoot to 15-month highs.

As always, though, the movement of the CBOE Volatility Index (^VIX) dipped under the radar. Based on options activity on the S&P 500, this widely watched – but poorly reported – gauge of fear and complacency among investors quietly slumped by more than 6%, edging toward the 20-point mark.

This means little to many investors. But savvy onlookers know that now is the time to pay more attention…In my column on volatility and the VIX a couple of months ago, I warned that a drop under 20 implies that investors are becoming more complacent about the market – and that it might be time to tighten your stop-losses, or lighten your positions as a result.

Moreover, a move toward 10-15 points is a signal to sell your positions, as it indicates that investors are buying significantly more S&P call options than puts. Such an imbalance suggests a high level of complacency, with a market correction usually imminent.

We’re not quite there yet. But that doesn’t mean you still can’t make money at current levels. The question is: Do you know how?

What You Should Do When the VIX is Low

When the VIX is this low – and trending lower – you can capitalize by buying put options, especially longer-term ones. The reason is two-fold…

  • Time: Long-term put options give you plenty of time for a market correction to occur, thus making you money. For example, if you buy a two-year put on the S&P 500, you’re betting that the index will fall at some point over the next two years – a pretty sure bet in my book. 
  • Low Volatility: What makes the trade even better is the fact that the VIX is low. That’s because when the VIX is low, it means stock volatility and options premiums are also low, which gives you cheaper entry points.

And when it comes to the price of options, it’s the underlying volatility of the stock in question that is a crucial factor. (Others include time to expiration, the share price and risk-free rate of return, but volatility is the key driver.) Given that the volatility number is low – as it is now – option prices are  correspondingly low.

Click here for the rest of Mr. Rahemtulla’s article, including useful volatility impact charts, at Investment U.


Next Article: TFN readers up 20% on Stillwater Mining (SWC)

Posted by Karim Rahemtulla · Filed Under Options 

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