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Nothing presented is financial advice, trading advice or recommendations. Everything presented is the author's ideas only. The author accepts no liability for its use including errors and omissions. You alone are solely responsible for your own investing and trading. There are considerable risks involved in implementing any investment strategies and losses can be large. Trade at your own risk.

 

 

June 26 2011  / Strategy Article

Understanding The VIX INDEX

Using the VIX To Gauge Market Direction

 

The VIX 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 this .VIX

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 index can 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.

VIX chart - index of stock market 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 at 125
April 8 - SPY at 126 - VIX at 24 - 4 SPY PUTS purchased for SEPT at 126
April 10 - SPY at 125 - VIX at 26 - 5 SPY PUTS purchased for SEPT at 125

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.

VIX chart - 10 years of volatility

 

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 presently be telling investors that overall, it is still a wait and see approach for the markets?

VIX chart - 20 years of volatility

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 that protection.

SUMMARY

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 downturns.

 
 

Disclaimer: There are considerable risks involved in all investment strategies. Trade at your own risk.
Stocks, options and investing are risky and can result in considerable losses. None of the strategies, stocks or information discussed or presented are financial advice, trading advice or recommendations. Fullyinformed.com is a private website. Everything presented and discussed are the author's ideas and opinions only.
By using this site, you agree to be bound by its terms of use. The full terms of use can be read here. If you do not agree to the terms of use, do not use this site. The author of fullyinformed.com assumes no liability for topics and ideas discussed, errors and omissions, ads and their content and external links. Any corporate insignia used are registered trademarks of their respective company or corporation and are being used for identification purposes only. All material copyrighted by FullyInformed.com. Reproduction in whole or in part prohibited. Copyright 2008

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