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2011 / Strategy Article
Understanding The VIX INDEX
Using the VIX To Gauge Market
Volatility Index and
How It Can Improve Your Investing
Volatility in the market is
something every investor learns to deal with.
Long term investors ignore the fluctuations in
stocks. They are unconcerned about volatility.
Others, such as myself, look at the VIX as a
tool of significant importance that can assist
in my investing decisions. The VIX is the CBOE
MARKET VOLATILITY INDEX. For some charting
programs the VIX historical volatility index is found by typing in the
symbol VIX but with a period before the V, like
VIX - DEFINITION
The VIX is an index on
the Chicago Board of Exchange which is measuring
and predicting the expected level of volatility
in the US Stock Market (primarily the volatility
in the S&P 500) for the next 30 days.
While many investors think it is reflecting
"today's" volatility, it is actually predicting
what level of volatility to expect over the next
30 days. This is why the tool is handy to have
in any investor's trading arsenal. Before the
VIX volatility index was created, investors had to rely on
instinct and experience. Now, thanks to the VIX
there is a clearer indication of expected
volatility. Understanding how to use the VIX
improve many investors' trading results.
Many investors consider the VIX a "fear
indicator". There is good reason to consider it as such.
When the market is in a downtrend, a correction, a
period of uncertainty or there
are investor concerns, the VIX will reflect the fear or
concern of investors as it will rise, showing that
stocks are moving erratically as often there are more
sellers than buyers which results in stocks falling
further than in an up trending market. When stocks plunge volatility moves
up. When the market is in an uptrend or there is less
uncertainty in the market, the volatility subsides. This
is also reflected in the VIX as the index will decline.
The chart below shows volatility for the past 12 months
(June 2010 to June 2011). I have marked periods of
higher volatility and those periods of lower volatility.
As I sell options I know from experience
that volatility will drive the price of options. During
periods of high volatility, option premiums,
particularly put premiums will rise, often dramatically.
In periods of low volatility, option premiums decline.
For those investors who buy options, volatility is
equally important. If, for example, an investor buys put
options to protect his stock holdings, during periods of
higher volatility, he will pay more for the puts, then
during periods of lower volatility. Therefore if an
investor is looking for protection or insurance against
a stock market downturn, it is best to consult the VIX
to time when to purchase put protection.
There are many investors who believe that any movement
of the VIX above 20.00 should be taken as a warning sign
that stocks are going to correct further. Those
investors will begin to purchase puts for protection in
larger lots as the VIX moves up from 20.00. They almost
always purchase a percentage of put options based on the
size of their portfolio. For example, an investor who
has 50,000.00 in the stock market might consider
purchasing a total of 15 SPY PUTS to protect the overall
portfolio. Most long term investors who use the SPY Puts
for insurance will buy at least 3 months out in time and
at the money. Let's take this hypothetical example:
(dates, VIX premiums, SPY prices are all fictitious)
April 2 -
SPY at 126 - VIX at 20 - 3 SPY PUTS purchased for SEPT
at 126. (In my example that would be SEPT)
April 4 -
SPY at 125 - VIX at 22 - 3 SPY PUTS purchased for SEPT
April 8 -
SPY at 126 - VIX at 24 - 4 SPY PUTS purchased for SEPT
April 10 -
SPY at 125 - VIX at 26 - 5 SPY PUTS purchased for SEPT
Total of 15 SPY puts purchased.
SPY puts value fluctuates enormously depending on
volatility and the time period purchased. Therefore many
investors will choose 3 months as a minimum. Others
however will choose 6 months.
By going out in time by at least 3 months, the investor
has some time before the puts expire and should the
market not fall, there could be some premiums in the
puts in order to recover some of the capital spent in
the original purchase of the spy puts.
The number of puts purchased usually depends on the size
of the portfolio. The larger the portfolio, the more put
contracts are purchased. There is no set rule or
formula. It all depends on the investor's level of
comfort. Some investors do not purchase SPY puts,
but instead will purchase PUTS on the individual stocks
or ETF's they are holding. Also, many investors purchase
100% insurance, meaning 1 put contract for every 100
shares of the stock held. Therefore if an investor has
500 shares of Microsoft, they will purchase 5 put
contracts to protect all 500 shares.
Using The VIX To Time The Market
The chart below looks at the past 10 years of the VIX.
Based on the belief that anywhere above 20.00 should
concern investors and commence the purchasing of puts
for protection, the chart below does show some value to
the strategy. Those investors who purchased puts in 2001
would have been insured against the 9/11 attacks and the
Bear Markets of 2001, 2002, 2003 as well as the 2008 to
2009 collapse. They also would have had protection for
the May to June 2010 pullback. The Japanese
Earthquake-Tsunami was an event that there was no
warning for. Investors therefore would not have had
protection. Presently investors who follow this strategy
would also be holding puts now.
Meanwhile during the period when stocks recovered in
2003 through to mid 2007, puts would only have been
purchased twice and since they are purchased in lots
depending on the rise in the VIX, an investor would not
have lost much capital from 2003 to 2007 when the VIX
seemed to indicate the market could correct.
The next chart below shows the VIX over a 20 year
period. This is interesting as it shows that during the
period from 1997 to 2003 an investor following the
strategy being discussed, would have held puts for
almost the entire period. Note also, of significant
interest is how the VIX was much higher for most of the
period than it is today, yet the number of blogs, news
sites and financial articles that are looking for a
possible stock market crash is much higher today. However the VIX is not reflecting
sentiment but predicting future volatility. The VIX
today is still indicating some concern on the part of
investors, but at 21.10, is not anywhere near as high as
it was during much of 1997 to 2003. Could the VIX Index
telling investors that overall, it is still a wait and
see approach for the markets?
Once puts are purchased, investors need to follow their
puts and can use a stop loss strategy to lock in profits
should the VIX begin to fall back with declining market
volatility. As well, many investors who purchase puts
hold them through to expiry as they are seeking
protection only and are not concerned about the cost of
The VIX is an excellent index worthy of every investor's
attention. It is a very simple tool to apply. It is also a
simple method to monitor changing market conditions and to
assist when preparing for possible market corrections and