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Implied Volatility (IV) is a measure of how much the
"market place" expects the price of an underlying stock or index
to move; i.e. the volatility that the market itself is implying for the
underlying stock or index. The VIX index represents the Implied Volatility
for the S&P 500 index (SPX), therefore giving us a prediction of the
potential size of future price swings for the SPX. Wall Street, in
general, uses the VIX to represent the volatility of the stock market as a
whole, and not just the SPX. One of the variables of pricing an option is
IV. Thus, when IV for an underlying stock or index increases, the price of
options on that stock or index increases. Conversely, when IV for an
underlying stock or index drops the price of options on that stock or index
decreases. For traders like us who write (sell) index credit spreads and
iron condors, we like higher IV because we can collect more premium for the
options that we write.
Implied
Volatility (IV) is also called the fear index. When the market goes down
the VIX goes up - i.e. investors are getting more fearful. On the contrary,
when the market rallies, IV drops and fear subsides because investors start
feeling more comfortable with the market. Therefore, there is an inverse
relationship between the underlying index or stock and its IV. Figure 1
shown below demonstrates the inverse relationship of the Russell 2000 index
(RUT)to the VIX. As you can see, when the RUT sells-off investors get
more fearful and the VIX climbs; and when the RUT rallies, investors
feel more comfortable with the market and the VIX subsides.
Figure 1
Sometimes
the VIX moves in the same direction as the underlying index or stock.
Figure 2 below shows that in May, June, and July of 2007 the VIX trended
upward along with the market. This is a sign that the market could be
topping-out and is ready for a pause or correction. The psychology behind
this is that even though the market is trending upward and
"looking" healthy, investors are getting worried that the market
is getting over extended and/or the fundamentals behind the economy are
slowly deteriorating. Therefore, when we see the situation where the VIX
(fear) trends upward along with an upward trending market we need to be
careful and watch the market closely for a possible correction.
Figure 2
Another
observation that we can see in Figure 2 is that the VIX many times will
increase just prior to an event such as the Federal Reserve Open Market
Committee meeting where they make the decision to either raise interest
rates, hold them steady or lower them. The VIX climbs because there is
uncertainty on what the outcome will be. This is what happened in late
June, as shown above, where the VIX spiked up to almost 19. However, as
soon as the Fed announced their decision on interest rates and the
uncertainty diminished, the VIX immediately deflated back down to 16. We
sometimes want to time the writing of our credit spreads with events like
this since the quick spike of the VIX will substantially increase the price
of the credit spreads options that we are writing (selling).
To
summarize, below are some general trading rules using the VIX when deciding
to open 30 to 40 day index bull put credit spreads, bear call credit
spreads or iron condor options: 1) If the VIX is holding steady and is not
dropping from day to day when we are about 30 to 40 days out to expiration,
we can usually take our time to open our spreads for that month and
gradually "collect" premium over a two week period. 2) If the VIX
is slowly dropping day to day when we are 30 to 40 days out to expiration,
we then will have to move more quickly and open our trades before the premium
of the credit spreads that we're selling "dries up". 3) Once we
open our bottom bull put spreads, and if the VIX starts to creep up from
the time we opened our trades, we need to closely monitor the VIX because
it could be warning us that a "storm" is coming, where we might
need to close our bull put spreads early and only focus on the top bear
call spreads for that particular month.
About The Author
Brad Reinard is Editor-in-Chief of Monthly Cash Thru Options LLC, a leading
index credit spread & iron condor options advisory newsletter, which
has the following track record: 92% 2009; 33% 2008; 63% 2007;
42% 2006; 50% 2005. The MCTO advisory focuses on a non-directional,
income generating options trading strategy using the DJX, SPX, SPY, OEX,
RUT and QQQQ indexes and ETFs. For more information on the
robust technical, fundamental & macroeconomic analysis that the
MCTO team performs weekly to help guide our credit spread and iron condor
trades, please visit www.monthlycashthruoptions.com or
call Brad directly toll-free at 877-248-7455. Brad has a B.S. in
Electrical Engineering from Columbia University and an MBA from the
University of Chicago Booth School of Business. He resides in the San
Francisco bay area with his wife and 3 children.
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