When markets are volatile you may hear the media come up with different explanations. But how reliable is that information? There are four myths about volatility you may often hear and why they may not necessarily be true.
What’s worse than being talked about? Not being talked about! That double-edged popularity sword is true for teenagers, celebrities, and you guessed it—volatility (“vol”). For years, vol was something you read about in dry financial textbooks or heard about from crusty old traders. And that was unfortunate. Because “vol” has always been an important tool when it comes to trading, especially for options traders.
Yet, as vol became more popular, particularly the CBOE Volatility Index (VIX), and more people gossiped about it, sure enough, mean rumors started circulating. TV pundits were saying things like, “The VIX didn’t tell me when the market would crash! It’s useless!” Or articles warned investors to shun the VIX, which apparently was to blame for market selloffs.
Though it seems like vol can’t catch any good press, there’s hope. Consider four things you might hear about vol that aren’t necessarily true—myths, if you will, that should be debunked and replaced with facts.
MYTH: The VIX drives the market.FACT: The market drives volatility.
Selloffs are bad when you’re long stocks. Those who complain about the VIX often have a vested interest in the market always going up.
When the market drops, uninformed pundits may blame the VIX. True, it can be hard to understand just what the VIX is. The formula is a bit complex. But conceptually, the VIX is fairly simple. It’s a weighted average of the implied volatility of out-of-the-money (OTM) S&P 500 index options (SPX).
Because VIX derives its value from SPX options, saying the VIX drove the market down, for example, would be blaming SPX options. As market participants (you, me, hedge funds, etc.) buy and sell SPX options based on how big or small potential SPX price changes might be in the future, it pushes the values of those OTM SPX options up and down. When prices go up, all things being equal, the VIX goes up. When price goes down, the VIX goes down. So, the VIX is a kind of indicator as to how much traders are pushing the SPX options prices up or down in expectation of what might happen in the future.
MYTH: Vol tells you where the market is going.FACT: Vol may help you choose a trading strategy.
talking heads may say the VIX is low. So the market is due for a
selloff. Or the VIX is high and the market is going to bounce. If it
doesn’t happen their way, they blame vol.
In point of fact, vol
doesn’t reliably predict market direction. Sometimes the market crashes
when the VIX is low. Sometimes the market rallies after the VIX spikes
higher—but not all the time. That inconsistency makes the VIX a
not-so-great directional indicator, which leads some traders to suggest
the VIX is useless. And that’s just plain wrong.
The VIX may help
you choose a strategy once you’ve determined your bullish, bearish, or
neutral market opinion. Remember: the VIX is just a measure of the
implied vols and, by extension, the extrinsic values of SPX options.
When vol is relatively low, it means the extrinsic value of SPX options
is relatively low, too. If you’re bearish, for example, and VIX is low,
you may decide to choose a strategy that benefits from low extrinsic
values, like a long put vertical or a long put calendar spread. If
you’re bearish and VIX is high, you may decide on a strategy that takes
advantage of the higher extrinsic values, like a short OTM call
Those strategies are bearish. But each tries to take
advantage of how high or low the extrinsic values of options might be.
Whether the VIX at 17 or 25 is considered high or low, as a trader,
you’ll still need to make a judgment call. But use that judgment to
inform your strategy, not your directional bias. That’s how you
potentially derive value from the VIX, which can move rapidly and
because of that, can quickly move against a position.
MYTH: Sometimes the VIX is wrong.FACT: It’s math.
VIX itself is never “wrong.” Saying the VIX is wrong is like saying SPX
options prices are wrong. And that statement can be tough, if not
impossible, to prove. Above all, it’s how you interpret VIX that
matters. It might indicate over-complacency in market participants on
one hand, or too much fear on the other. Keep in mind the VIX is not
taking the pulse of the market. It’s taking the pulse of market
participants. Are traders complacent or fearful? If traders expect a
quiet market, they may sell SPX options and push prices lower. The VIX
goes down, indicating complacency. If traders expect drama, they may buy
SPX options and drive prices higher. The VIX goes up, indicating some
measure of fear or uncertainty. The VIX tells you what the people
trading the markets are thinking. Do you want to join them, or not?
As a trader, what’s key is your judgment as to how you’ll respond to movements in the VIX.
MYTH: Overall vol is just on the S&P 500.FACT: TD Ameritrade has an overall vol for most stocks.
FIGURE 1: VOL INDEX. On the Analyze tab of your thinkorswim platform, add Vol Index into the Watchlist. Source: thinkorswim from TD Ameritrade. For illustrative purposes only.
Beyond our myth-busting, consider this bonus fact! VIX options aren’t based on the VIX; they’re based on /VX futures.
Before the cool kids start bad-mouthing VIX options, let’s head them off with some facts about how they’re priced. When you look at VIX options and compare them to the VIX’s price, a put with a strike that’s, say, two points below the VIX looks less expensive than a call that’s two points above the VIX. Why?
A key concept in option pricing suggests options are priced off their hedge. Stock options are hedged with their stocks and are priced off the stock’s price. But the VIX itself is a cash index that isn’t tradable. If you’re trading VIX options, what’s your hedge? VIX market makers use /VX VIX futures—specifically the /VX future that expires at the same time as the VIX options.
If you type in the root futures symbol /VX in the Trade page of the thinkorswim platform, you’ll see all the /VX futures, along with their days to expiration. You won’t see any VIX options listed. And if you type in VIX, you’ll see VIX options, but not futures. But if you note the price of a particular /VX future, say the September /VXU8, and compare it to the Sep VIX options, suddenly the VIX option prices make sense. The call and put at the strike closest to the price of the /VX future will have roughly the same price. The intrinsic value of the in-the-money (ITM) calls and puts will match the difference between the strike price and /VX future’s price. And the OTM options will make a lot more sense if you compare them to the /VX price rather than the VIX itself.
Now, go spread the facts about volatility!
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