One of the indicators that we like to watch in the marketplace just to get an idea of where investor sentiment may be is the CBOE Volatility Index (VIX). The VIX is derived by looking at implied volatility levels for put contracts on the S&P 500 index options. When those implied volatility levels start to go up, it’s a sign that investors are concerned that there’s increased uncertainty in the market.
Typically, the certainty that we see in the market comes when the market is moving higher; the uncertainty tends to creep into investors’ minds when we have the potential of a pullback, when investors are growing increasingly concerned that we could be dropping lower and lower.
I review the VIX’s chart in video to show it has broken out of a trading range between 15 and 12.50, which has been this safety zone for the VIX. It dropped down below there momentarily in the middle of March, but on the chart I show you that the last time the VIX got to higher levels than where we currently are is when we were heading into the deadline for the fiscal cliff at the end of 2012. So, the VIX popped up momentarily in February, and we’re getting up into these elevated levels again.
If we continue to see the VIX rising higher and higher, it will mean two things. One, it will mean that we’ll probably see more implied volatility increase throughout the market, which means options will become more expensive. Implied volatility is tied to one of the option Greeks that you’ll often hear referred to as vega.
There’s delta, there’s gamma, there’s theta and then there’s vega. Vega is one of the option Greeks that tells you how your option premium is most likely going to respond to fluctuations in implied volatility. If you are long a call option or long a put option, it means you have a positive vega. That tells you that if implied volatility levels are rising, then the value of your call or your put is most likely going to be rising, as well.
Vega is non-directional as far as the price of the underlying security goes. It doesn’t matter if the stock is moving up or down; it tells us that if implied volatility levels are increasing, then uncertainty is increasing. Whenever uncertainty increases, option prices tend to go up.
So, for long calls or puts, if we see a nice rise in implied volatility levels, we have a positive vega, so we would most likely see that the long calls or puts that your holding will see a boost in their premium value due to that increase in implied volatility. Now, it also means that new trades that we are looking to enter may a be a little more expensive than they might have been a couple of days ago but, again, if you are anticipating that the VIX is going to continue rising, you’re still trying to buy low and sell high with volatility.
Investor Place advisors John Jagerson and S. Wade Hansen are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.