We recently talked about the relatively low levels on the CBOE Volatility Index (VIX), but the VIX can typically help options traders decide whether it’s better to go long options or go short options.
The VIX right now is really, really low. For those of you who may not know, the VIX is a measure of market fear. That sounds a little weird, but the way it does that is it basically measures the excess premium in the S&P 500 index options and kind of backs it out through the options calculation that we use to arrive at the theoretical value. It calls that over or under implied volatility.
The higher implied volatility actually is, it’s thought of as a very fearful market. So, when implied volatility’s really high, what’s happening is that traders are pricing in the potential for a really big move.
So, when implied volatility levels on the VIX are really low, that means traders aren’t pricing in much of a move at all.
If options prices are really inflated at levels like we say in May 2012 or the end of December 2012, you’d think, “That’s a good time to sell [write or short] options because they’ve got extra premium. We shouldn’t buy options at those levels.”
By the same token, the thought would be that we should be buying options when the VIX is low and not selling them.
Actually, it kind of evens out.
The market is a really interesting self-balancing artificial organism, if you will, in that, yes, buying options when the VIX is low does make sense because it’s cheap, but on the same hand, if investors are right about their expectations for the lack of any big moves to the downside or upside, then we’re expecting that those options aren’t going to accumulate value quite as a fast as they would in a more volatile market.
So, there’s always going to be a little bit of a trade off. The same thing is true if the VIX is really inflated, meaning that option premiums are really high, so options writers may make a very big premium in that situation but if traders are right in their expectations, they could also be taking a lot more risk in those market conditions.
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.