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Volatility Secrets: News for Show, Vol for Dough

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August 1, 2014

Our trading days are filled with news—good news, bad news, news you consider important, news you ignore. Of course, how you interpret news is up to you. But there’s no mistaking the one signal—implied volatility—that can tell us how the market itself feels about news. Simply put, implied vol measures the magnitude of an index or stock’s potential price change. It goes up when the market is uncertain or fearful about what a headline might mean for future price changes, and down when news makes the market confident.

Sometimes, though, market volatility itself becomes news. And talking heads sound the alarm when the VIX—the Chicago Board Options Exchange (CBOE) volatility index—spikes higher. The VIX might not be reacting to news at all. But scary headlines about volatility can make novice investors skittish and afraid to act.

Sure, it’s a free country. And you can choose to trade or not, depending on your nervous system. But savvy traders understand that higher volatility may actually signal potential opportunities. In fact, veteran traders may use strategies that leverage the very thing that’s often scary to novices. How? Because they understand that when the VIX is higher, options premiums don’t just increase in lockstep. They do so exponentially.

Leg Bone Connected to the Shin Bone

Traders know the VIX is calculated using out-of-the-money (OTM) SPX options prices. Those prices move higher and the VIX goes up, when traders buy them as a hedge or speculation against a large SPX price change. When option prices move lower because traders are selling in expectation of smaller price changes, the VIX moves lower. The relationship is essentially mechanical.

Traders may have an idea that short-option strategies like short straddles, for example, present opportunities when implied vol is higher, and wait for a higher VIX before they either open positions or increase position size. The higher the volatility, the higher the credit received for a short straddle—all other things like SPX price, strike price, and time to expiration being equal. That higher credit can mean higher potential profits and wider break-even points for a short strangle, which is why the strategy may be more attractive when volatility is higher. That said, short strategies in higher volatility environments pose great risk due to the wild swings that could drive a short option deep in the money very quickly. For that reason, you will always need to be aware of the increased risks as volatility increases, but as it does, how much higher is the credit? 

Put to the Test

Let’s use some actual numbers for the dollar amount that a change in the VIX means to SPX prices. The difference between the VIX at 14, and the VIX at 20, is due to SPX option prices. But how much higher are the SPX options when the VIX is at 20, than when it was at 14? A little bit higher, a lot higher, or somewhere in between?

FIGURE 1:

For illustrative purposes only. Not a recommendation

To answer that, I did a little study using the thinkBack tool on the Analyze tab of thinkorswim®. thinkBack lets you look at end-of-day stock-and-option prices for every trading day going back to 2003. Set the date in the upper-right-hand corner to open up the stock and option prices for that date. It’s very handy for this type of analysis.

I looked for trading days where the SPX prices were very close—only a few points difference—and where the expirations were the same number of days in the future. The dates I found were July 9, 2013, and October 8, 2013. That removed much of the influence of the SPX price, and days to expiration on the prices of SPX options. The main reason for any difference in the option prices would be volatility. So, same SPX price, same days to expiration. Only the VIX is different. Here’s what I found:

The table above is divided into two sections showing SPX options with nine days to expiration, and 37 days to expiration. The strike prices are down the middle. On the left hand side are out-of-the-money SPX option prices, when the VIX was 14.50. On the right are out-of-the-money SPX option prices when the VIX was 20.34. The strike prices 1650 and lower, show SPX put prices, and the strike prices 1655 and higher, show SPX call prices. You want to look only at out-of-the-money options because their values are purely extrinsic, and clearly illustrate the impact of higher and lower volatility on their prices.

The VIX at 20.34 is 40% higher than the VIX at 14.50. You might think that the SPX option prices are higher by a similar amount but they’re not. In the case of the 1500 puts with 9 days to expiration, with the VIX at 14.50 they were .20. But with the VIX at 20.34 they were 1.35, or rather 6.5x greater. The 1500 puts with 37 days to expiration were 2.85 with the VIX at 14.50, but 7.55 with the VIX at 20.34—more than 2.5x greater.

The 1650 puts with 9 days to expiration, which were closer to the money, were 13.00 with the VIX at 14.50, and 18.55 with the VIX at 20.34. That’s 1.4x higher, which is closer to the increase in the VIX. The 1650 puts with 37 days to expiration were 28.70 with the VIX at 14.50 and 37.30 with the VIX at 20.34. That’s about 1.3x higher. 

Follow the Risk

This analysis illustrates the actual premium change for the SPX options that pushed the VIX from 14.50 to 20.34. And it's important to understand that relationship. It's not the VIX moving higher that makes the SPX option premiums go up. It's the SPX option premiums that make the VIX go up. In fact, the SPX options moved up a larger percentage, depending on their distance out of the money, than the VIX. The further out of the money the option was, the greater the percentage price change. The closer to the money the option was, the smaller the percent price change.

That means the VIX is really a shorthand for how much premium is available in SPX options. Because SPX options represent liquid and efficient markets, and they're used to calculate the VIX, the VIX is a responsive indicator of potential market risk. This is one good reason traders ought to check the VIX daily, arguably giving it even more attention than underlying trends.

Also, note the SPX was the same price, but the VIX was different, suggesting the SPX price itself isn't necessarily an indication of fear or confidence. That information is packed into the prices of the SPX options, and makes the VIX a forward-looking indicator.

Does selling premium when vol is higher guarantee profits? Absolutely not. Is volatility the only thing to consider when trading? Nope. But this information is a kind of dollar validation for using volatility as a basis for a strategy. Arguably, you should be looking at the VIX even before looking at the price of S&P futures pre-market. For a well-capitalized trader who is comfortable employing short-option strategies, the potential reward for keeping a sharp eye on the VIX can mean you potentially dont make a little more. You can potentially make a lot more for the same level of risk.