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VIX Grew up. Have You? Why the Volatility Index is Still Relevant

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January 1, 2012
CBOE Volatility Index VIX
Fredrik Broden

Back in the early ’90s, when the CBOE's VIX volatility index was first concocted, I was sitting in a class at the University of Chicago GSB taught by Robert Whaley, who had created the original VIX a couple of years before. I was already working on the trading floor, trying to square up what I was hearing in class and what I was seeing on the job. I could see the volume of buy orders and sell orders flow into the trading pits, and see options prices change in response, and then see how those option prices would change the implied volatility. That VIX indicator looked like a handy tool to gauge the fear or complacency in the market rather than have to watch the order flow.

And later, when the VIX was published as an index everyone could see updated live on trading platforms, more and more people started to believe a low VIX was an indication the market might be too complacent, overconfident and over-bought. A sell-off might be in the offing. If the VIX was high, fear was rampant. And while everyone else was panicking, some thought the high VIX was an indication the market would bounce back.

Maybe that's true. Maybe not. There's been a lot of chatter this past year about whether the VIX can predict the direction of the market, whether it's is a leading or lagging indicator, whether it's useful or not, etc. Some people are now thinking that the VIX is unreliable. Useless. Wrong, even.

It's Not the Vix, It's the Trader

It's not the easiest calculation in the world, but the VIX is just a weighted average of the out-of-the-money SPX options in the first two expirations, and then adjusted to mimic the volatility of an option with 30 days to expiration. Because it works off the actual bid/ask prices of those SPX options, it's never “wrong.” It's just a calculation. It is what it is. But what about “unreliable,” or “useless?”

To a savvy trader or investor, those are the wrong questions. While everyone else is asking, “The VIX is here, where's the market going?,” you need to ask, “The VIX is here, so what strategy am I going to employ?” You can't control where the market is going. Even picking direction is basically 50/50. But you can control the trading and investment strategy for your money. To me, the VIX is less of a market indicator and more of a strategy indicator. While less informed market participants and “talking heads” focus solely on the VIX as a number, many experienced traders aren't put off by how high or low the VIX is. They watch it in order to make more informed decisions about strategy.

As a trader, you have to stay a step ahead of the noise. Stocks, indices, commodities, indicators—they all go up, down, or both, every day. Analysts usually try to attach some news or reason to try to explain why the market did what it did. But that's looking backward. A trader has to be forward looking. And the VIX can help you with that.

Using VIX 2.0

Think about the VIX all by itself for a moment, divorced from the rest of the market. If the VIX is going up, it means the out-of-the-money option prices, which are used in the VIX calculation, are rising. What's making them go higher? Mechanically, it's because market participants—traders, investors, money managers, you, me—are trying to buy more of them. That buying pressure pushes up the prices of options, which, in turn, pushes up the VIX. So, if you see the VIX staying pretty constant, it means the out-of-the-money option prices aren't moving much higher or lower, which could mean there really isn't any strong buying or selling pressure on them. You don't have to know why, necessarily. Again, it just is what it is.

Now, combine the VIX that's not moving with a market that is moving lower. If the market's moving lower, but the participants aren't bidding up those out-of-the-money options, chances are it's because they're either already hedged or are less leveraged, and a sell-off isn't that scary to them. They don't perceive they have the risk they might have had. And maybe that's why the VIX can be seen by some as not that useful ("Hey! The market's selling off, but the VIX isn't going higher!").

But think about the VIX as a tool to make more informed strategies, rather than to predict market direction. Is it high or low relative to where it's been for the past few weeks? What you're trying to do is gauge the overall level of fear or complacency in the market, and how that's impacting option values. Here's how.

1. IF THE VIX IS LOW, that's an indication that market participants are a bit complacent, and option premiums are relatively low, too. It doesn't mean they're undervalued. It just means there's less extrinsic value in those options than there would be if the VIX were high. That makes some option strategies, such as covered calls, naked short puts, or short verticals, for example, less attractive because the lower option values means less credits taken in for those strategies, which decreases potential profits and increases potential risk.

Strategies such as buying slightly in-the-money calls in further expirations as a stock replacement strategy can make sense, particularly if you sell nearer-term expiration out-of-the-money calls against them. It's like a covered call strategy, but when you use the in-the-money call instead of long stock, you have lower capital requirements and lower risk if the stock drops sharply. Also, in a low-volatility environment, the long calls have lower extrinsic value, making them less expensive and have lower risk.

That's a straightforward transition from a covered call, which is buying stock and selling an out-of-the-money call.

2. IF THE VIX IS HIGH, that's an indication that there's a lot of uncertainty in the market, with fear about what might happen in the near term future. Often, the VIX is higher when the market has sold off sharply. Instead of buying stock, you might consider shorting a naked put. This is a strategy some consider when the market or an individual stock has sold off and volatility, i.e. the VIX, is up. The reason is if the stock has hit a recent low, the put is going to have a greater value because the stock price is down and volatility is higher. When you sell an out-of-the-money put for a higher credit, your cost basis for the stock is lower if the stock price declines further and you're assigned on the put. And that means your maximum loss is lower and your potential profit is higher. (For more on selling naked puts, see “Naked Short Dos and Don'ts,” thinkMoney, Fall 2011.)

But what if the market moves up or down, and the VIX doesn't change much at all? A trader might scan the rest of the market, from the S&P 500 to the NASDAQ composite, bonds, gold, oil, the US dollar and bell-weather stocks. If, say, the market is down, but larger stocks are up, then the VIX could be indicating the market isn't in “panic mode” quite yet. Alternatively, if the equities in general are up and you expect the VIX to be lower and it's not, that might indicate growing fear and uncertainty in some of the market participants who are still buying those out-of-the-money options as protection.

The point is that you don't have to be a hardcore option trader to use the VIX. Even novice investors who are getting started with options can use it to help make simple adjustments to their strategy that can potentially work to their advantage. The VIX is simply a tool. Whether it's good or bad for your trading depends on how you interpret it. It is what it is.