There are two common misconceptions that many beginner options traders have about how to track volatility with the VIX.
The CBOE Volatility Index, or VIX, is calculated using a rather complex formula to derive expected volatility by averaging the weighted prices of out-of-the-money puts and calls.
If you’d like to learn more general information about the VIX and how it works, click here.
Fortunately for us, the calculation is performed by the Chicago Board Operations Exchange. So we don’t have to perform complex mathematical calculations to derive volatility levels manually.
2 Mistakes Traders Make When Learning How to Track Volatility With the VIX
First, the VIX uses both puts and calls to calculate its value. However, I’ve stumbled upon several articles and videos over the past few years that forget to mention that calls are involved in the calculation to the same extent as puts.
Second, because the VIX is often referred to as the “fear indicator,” it’s assumed that VIX levels will only move higher when the stock market moves lower.
Put options historically tend to increase in volatility much more rapidly when markets move lower. So if the market begins moving higher and options traders believe the market will continue moving higher, the level of volatility can potentially rise to the same degree in the VIX.
So don’t assume that VIX levels only rise when markets are moving lower. In reality, VIX levels move higher when volatility rises, regardless of which direction the market is favoring at the time.
And because the VIX measures implied volatility levels of the S&P 500, it’s fair to say the VIX is a fair representation of the volatility level of the broader market.
In other words, if VIX levels are unusually high, there’s a strong chance that the majority of near-term options are overvalued at the time. That’s because overall market conditions are implying a high level of volatility and trading range over the next month.
If VIX levels are low, the majority of options will be undervalued because overall market conditions are implying a low level of volatility over the next 30 days.
The image below is a VIX chart updated daily over a period of one year. On the right side of the chart, VIX levels are shown ranging from 10 to 32.
As a general rule of thumb, if the VIX is below 20, the current market sentiment implies that options are fairly priced and a portfolio that consists of 70% long options positions is reasonable.
If the VIX begins moving above 20, options will become a bit overvalued. That means shifting part of your portfolio into neutral and short positions may not be a bad idea.
If VIX levels rise above the 25 level, the market is exhibiting high volatility levels.
That means buying options during this period isn’t a great idea because volatility can decrease rapidly and you can get caught in what is called a “volatility crush.”
These occur when volatility moves from extremely high levels to low levels in a short period of time, causing overpriced options to decrease in value rapidly, even though the underlying asset stayed at or near the same price levels.
On the other hand, buying options when VIX levels are low can help you gain an edge when levels rise quickly… That’s because options that are long VEGA will increase in value even though the underlying asset maintains the same price levels the entire time.
Don’t underestimate the power of implied volatility.
It can cause the price of an option to increase exponentially — and decrease just as quickly — while the underlying asset remains at or near the same price levels the entire time.
The More Diversified the Portfolio, the More It Will Behave Like the Overall Market
Keep in mind, not all stocks follow the overall market, and some stocks may exhibit extremely high levels of volatility when the overall market is calm, and vice versa.
There could also be times when the overall market is volatile, but an individual stock is barely moving. You have to consider every asset and its options individually.
With that said, most traders don’t trade just one option at a time.
When you put together a portfolio of several different options, it will begin to react more like the overall market .
So that’s when knowing how to track volatility with the VIX will become important.
Wishing you the best,
Senior Strategist, WealthPress