Last year we saw levels in the (VIX) CBOE Volatility index reach soaring heights and near record levels. As proclaimed by my brokers over at thinkorswim.com retail investors have a very difficult time timing and making money trading the index. It is best used as an indicator for retail investors as a guide to position sizing.
We reached the spiking high of 96.40 during our large market sell off last fall. This is an incredible feat for it has only reached this high twice before. Once in the 1987 crash and again we flirted with triple digit highs in the 2000 – 2001 dot com debacle. An option trader will relish this sort of environment, for price increase substantially for the options markets. out-of-the-money options have premiums matching in-the-money and can provide big profits for a trader.
example: If company (XYZ) was trading at $50 dollars and we walked into a large sell off with 7-9% volatility, or 90 on the (VIX), we may see the equity sell down to $40 or even $35. With the (VIX) trading above 70 we will see option pricing explode. This gives traders and investors the ability to reposition with covered calls, naked calls and naked puts in the short term. Normally these trades can take six months to a year for a good 20% profit to set in, but when short term calls and puts, one or two month expiration, have high prices a 20% profit can be achieved in a quarter or less. As a trader selling a one month expiration call at high volatility brings in credit for his/her account immediately. If the stock rallies higher the trader will need to purchase the stock equal to as many contracts sold. If the market continues to sag then the traders will do nothing. It is important for the investor that he/she has the capital available to purchase the equity when, or if, the stock climbs or he/she will be called out at a loss when the option expires. If the trader stays and watches the postion an acceptable margin of safety is achieved.
Other considerations for the (VIX) are not to trade the instrument outright. Floor traders use the (VIX) as a hedging tool but for the retail investor this can proof dire. In times of dystress, like last fall, the (VIX) will move large spans in a short time. Any account under $100,000 with a 0.5% or 1% risk ratio could be seriously damaged in a very short time. If one were to use the (VIX) as a trade it would be very important to stay with the trade at all times and use very little capital.
The volatility index is best used as a guide to the near future for options and equities. The index provides us with a sort of crystal ball into the moves the market will make in the short term. Directly correlated to the size of the market moves it is possible, as a retail or semi-professional, to use the index in position sizing, setting stops, and time horizon. At (VIX) around 40 indicates the general market has the posssiblity to run 2-3% any given day. Using this information can really help with choosing the width of condors and butterflies. If you invest or trade a stock with a beta of 1 it would be safe to asssume that stock could move 3-2% and stops need to relfect that. For the long term investor any loss occured in a high volatility time may take longer than expected to return, and purchases made during these times, for the longer term investor, could return short than normal.
New editions to the library… feel free to leave comments.
Stay hedged, stay happy!