Traders can’t engage in options trading without understanding the VIX, the Options Volatility Index. The VIX chart is something that needs to be looked at and analyzed at least weekly to understand the overall state of the economy and the future expectations of all market operators.
The VIX is a measure of the expected volatility of the US stock market, and it reflects traders’ future expectations. The value of the VIX rises substantially in times of uncertainty (or fear) due to macroeconomic events affecting certain markets or the overall economy and declines in times of certainty or low volatility.
Normally a decline of the index is gradual and steady, conversely a rise can be unexpected and steep determining an outbreak of the index which can determine panic in the market. That is why the VIX is commonly referred to as the Fear and Greed Index.
The Correlation Between the VIX and the Stock Market
I would suggest you have a look at the chart of the VIX from your brokerage account and study its fluctuations. Then compare these fluctuations to those of the main market indexes like the S&P500 (SPY), the Dow (DIA), the Russell 2000 (IWM), and the NASDAQ (QQQ). You will easily spot that there is a negative correlation between the value of the VIX and the stock market. This means that when volatility, uncertainty and fear spread the VIX will rapidly rise, and the stock market will rapidly drop. This correlation can be used by option traders as a dashboard when trading advanced options strategies.
In fact, as an option trader you should be aware that an increase in the value of the VIX translates into an overall increase in the value of implied volatility in the market, and, conversely, its decline translates into a reduction in implied volatility. This affects the way options are priced by market makers as implied volatility is a main component of the options’ theoretical value.
When looking at specific companies, you should compare their chart to the VIX chart. When there is fear in the market and the VIX spikes up, normally 90% of all the companies in the stock market will be affected and drop in value. However, a few companies, despite the high volatility in the market, will not follow and continue on their upward trend if backed by strong news and/or financials.
As an option trader you will need to analyze stocks charts and indicators and decide which underlying security is a feasible candidate for a good trade. Then you may want to go ahead and analyze different options strikes. Your goal is to decide which options strategy offers the highest chances of success considering all the variables in the market.
Implied Volatility Discrepancies and Volatility Skews
Something to keep in mind when picking the best strike prices according to your strategy is that there are as many implied volatilities as many options available on that underlying security. In other words, each option has a different value of implied volatility and the sum of all these values is reflected in the VIX.
This determines a situation where options with different strike prices and/or expirations for the same underlying can have in certain cases significative discrepancies in their premiums - due to different values of implied volatility.
Experienced option traders can take advantage of these discrepancies called volatility skews and trade strategies in which they are not interested in the direction of the market and profit solely for effect of changes in implied volatility.
Hope you got an overall understanding of the importance of monitoring the VIX for experienced options traders. I am aware that volatility is not a straightforward concept and may sound overwhelming to most. For this reason, I will try to publish more videos and posts in the near future on this subject.
I’ll see you on my next release of the Options Trading Diary.