Reversal Tracker - COMPLIMENTARY 2 Week Trial Offer

COMPLIMENTARY Booklet: Smart Trading Techniques

Trader's Edge is offering a complimentary booklet, Smart Trading Techniques: How to Profit from Time Value Decay Writing S&P 500 Credit Spreads. John Summa, a well-known options trader and advisor, shares his time-value-friendly strategy for trading options on the S&P 500 futures. Why not put his experience to work in your portfolio? Get your copy now!

What is the VIX?

The VIX was introduced in 1993 by the Chicago Board of Trade. It was a weighted measure of the implied volatility of eight S&P 100 at-the-money put and call options. Over the last decade it has been expanded to the broader based S&P 500 futures index, which allows for a more accurate gauge of future market volatility. VIX level above 30 is generally associated with a high amount of volatility due to investor fear or uncertainty in the market. VIX values below 20 usually reflect low investor fear.

Traders who wish to speculate on market volatility may want to consider taking a position in CBOE volatility index (VIX) options; it is a key measure of the market expectations of near term volatility conveyed by S&P 500 index option prices. This creates a great arena for a savvy investor to write deep out-of-the money overvalued options on the S&P 500 index. With great liquidity the S&P 500 is a great for selling options. The proper way to use the VIX is to look at where it is today relative to its 10 day moving average. (The higher it is above the 10 day moving average, the greater the likelihood the market is over sold and a rally is near. On the opposite side, the lower it is below the 10 day moving average, the more the market is overbought and likely to move down in the near future.)

Now that we have established what the VIX is, we can take the next step and explore the best way to use the ups and downs of the volatility to trade options. When the fear in the market is high and the VIX is over 30, it is an ideal time to write put options on the S&P 500. The fear in the market creates huge premiums and the ability to sell put options deep out-of-the-money that tend to be overvalued. To put things into perspective, on 3/17/2008 the VIX spiked to over 35 and the S&P 500 index was trading around 1260. The put spreads in the May contract that were sold (1025/1075 put spreads @ 4.50 pt.= $1,125) were extremely overvalued. Within one week the S&P 500 rallied nearly 95 points to 1355 and the VIX dropped to around 25 which is a 28% drop in volatility. The subsequent change in the May put spread was just as dramatic. After the rally and the fall in volatility, they were trading around 1.30 points or $325 which is about a 70% drop in premium. As you can see the results can be outstanding when selling on high volatility.

On the other side of the coin low volatility and the VIX is trading under 20 presents a great opportunity for the option buyer. As in the example above, it is safe to say that buying an option on low volatility MIGHT result in a sharp gain in option prices. The reason for my thinking, unfortunately for the buyer is the time aspect. Only a small percent of the time can the buyer capitalize on an option increasing in value because of time decay. Since over 80 percent of all out-of-the-money options expire worthless it can be said that selling on a high VIX is probably a better bet than buying options on lower volatility.

Determining market direction using the VIX incorporates a wide range of option data.

The VIX has an inverse relationship to the market. A low VIX, below 20, indicates traders have become somewhat uninterested in the market and may indicate a sell off. As the market moves lower the value of the VIX increases and this may signal an impending upward move. A falling stock market is seen as more risky than a rising stock market. The higher the implied volatility and the more expensive the options become, especially the puts. This is one of the main reasons why an investor can write a put option or put spread a lot further away from the market than a call option or call spread. Markets ten to slide faster than they glide.

Like most other indexes the VIX tends to move in cycles. For professional option traders, it can be (and should be) a great indicator of price movements. As I mentioned above, high VIX values imply overvalued options. When an option is overvalued an option trader would look to write options and collect premium. The underlying logic here is that once the overall market sentiment achieves status quo and becomes more neutral the options would quickly lose their value.

When VIX values are low - as we saw during 2006 (the VIX was as low as 11.12) options values will follow and be low as well. That might be a good time to look at various buying strategies such as calendar spreads or bull call spreads.

Here is a great comparison in option prices. On 3/23/06 the S&P 500 was trading at around 1302 with the VIX trading roughly at 11.17. The May 1350/1380 call spreads were trading at 5.00 points. Two years later the S&P 500 on 3/25/08 is trading at about 1350. We can today sell the May 1450/1480 call spreads for proximally 5.10 points with the VIX trading at 25.80. These spreads are 50 S&P points farther out-of-the-money than the ones on 3/23/06 and have similar premium. This allows us to sell calls and call spreads twice as far out-of-money for about the same credit. This increases our probability of the calls expiring worthless. This is another example of selling on high volatility where an investor can capitalize on selling both puts and calls.

Using the same dates and prices of the S & P 500 as above. On 3/23/06 the 1180/1230 put spread closed at 3.70 points. Two years later on 3/25/08 an investor could sell the same 1180/1230 put spread for 6.00 points. In conclusion, seeing both the put and call example above should remove any doubt about selling options on high volatility. An experienced trader should easily be able to design a strategy that best fits your investment goals.

COMPLIMENTARY Booklet: Smart Trading Techniques

Trader's Edge is offering a complimentary booklet, Smart Trading Techniques: How to Profit from Time Value Decay Writing S&P 500 Credit Spreads. John Summa, a well-known options trader and advisor, shares his time-value-friendly strategy for trading options on the S&P 500 futures. Why not put his experience to work in your portfolio? Get your copy now!