Discussing Volatility “The VIX”

In an earlier post, we looked at how vega can either have a positive or negative affect on any given position since it is a measure of volatility.  So what is volatility?

Volatility is loosely defined as the “range” a particular stock or index may trade within.  For example, a highly volatile stock may move +/- $4 on a given day, but a stock that is not as volatile may only move +/- $1 at any given time.  The more volatile a stock, the more it will move around.  Think back to 2008, when the market was going through those daily wild swings, where it would be down 700 points one day and up 100 points the next day.  Compare that to today, where the market trades within a much narrower range and the large wild swings of 2008 have subsided.

Each individual security (stock or index, etc) has its own volatility, but the VIX provides an implied volatility reading on the S&P 500 index.  The term “implied” means that the market is implying that the index may move this given amount.  In reality, this move or may not occur, but that is what is being implied right now!!  So how do you convet volatility to a number that you can understand.  Here is the secret:

• Take the volatility reading and multiply it by the square root of (number of trading days left, divided by 252)

For example:  Let’s say that the VIX is at 35% and there are 15 trading days left.  You would take 35% and multiply it by √(15/252), so you would have 35% * 0.239 = 8.54%.  So the market is implying that the S&P 500 index is expected to move 8.54% within the next 15 days.  So that gives a range of +/-4.27%.

So why use the VIX?  Generally speaking, it gives me an indication of what the market is thinking right now in regards to the S&P500 and helps me plan the type of trades I should place.  For one, when volatility is high, I won’t trade straight calls/puts because you end up paying a lot of premium for the options.

Here is a graph of the VIX over the past 20 years!

If you study the graph closely, you will notice one common theme.  Each time the VIX hits a high, the market seems to rally.  That’s why a lot of traders say, “when the VIX is high, its time to buy”.  But, you must judge the truth for yourself and come to your own conclusion.