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Volatility Index (VIX)
Yesterday showed you a useful tool in hedging your options portfolio, the SPDR S&P 500, or the SPY (spyder trust). So far we’ve gone over how to gain broad market exposure with the largest 100 companies in the NASDAQ and exposure to the S&P 500, two important indices for options traders. Today we’ll look at an index that isn’t as simple to understand, the CBOE Volatility Index, or the mighty VIX. What is the VIX: The Volatility Index, or the VIX, is a measure of fear within the markets. How an index can determine fear is beyond me, but it’s there. The VIX measures the implied volatility found in the S&P 500 index options. It’s currently measured in percentages with anything under 20 representing complacency in the options market while anything around 25 and above represents a potentially volatile environment. Why use the VIX: I’ve never traded the VIX but I could only assume options traders purchase and sell contracts on the VIX as a way of hedging against or gaining exposure to volatility. Volatility is what gives options the lifeblood they need to make successful trades. The more volatile the market, the better chance an options trader has of making successful trades. Recession talks, rising commodities prices, or any other major events could swing the VIX one way or another and it is possible to gain exposure of that volatility through VIX contracts. VIX Options Structure: The VIX trades at $1 increments with a $0.05 bid/ask spread. The VIX does not represent actual dollar amounts but contracts trade as such. Remember that the VIX is a percentage value on the overall volatility of the S&P 500. The VIX helps to determine the implied volatility of the S&P 500 index options. It helps to predict movement in the S&P 500 over the next 30 days through a fairly simple mathematical formula. The following was taken from Wikipedia: Assuming the VIX is reading 18.53%. Using the formula VIX % / sqrt (12 months), we can predict with about a 68% certainty, the S&P 500 will move either 18.53/3.464 % up or down, or 5.35% over the next 30 days. The VIX is a simple but useful tool in determining the overall volatility of the market. One can argue that the VIX does not determine individual sector volatility. In any event, it gives a simple view of the volatility in the market and can be used to an option trader’s advantage. The higher implied volatility climbs, the higher option premiums become and as a result gains (and losses) can be greater. If you’ve ever traded an option prior to some breaking news (earnings report, press release), I’m sure you’ve noticed the day after the news has been released, almost always the options price drops. That’s a result of a drop in implied volatility. The VIX can help figure out the overall implied volatility of the market. Don’t forget to check in with the VIX every day! |
Volatility Index (VIX)
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