Pay attention to the VIX, but don’t just follow the crowd.
Of all the options market’s measures, implied volatility is the most nuanced, because it deals with what is unknown: the future movement of stock prices. Practitioners discuss volatility in terms so technical that anyone unschooled in high finance couldn’t follow the conversation. Yet volatility is the one area of the options market that almost everyone acts as if they understand. This is because of the Chicago Board Options Exchange’s Volatility Index, or VIX. During the week, the VIX slid below 15 and set a 52-week low of 14.30 on Tuesday, inciting much palavering among pundits and prognosticators. So what does it mean if VIX is below 15? Probably nothing. The same is true when it crosses 20, a number pundits have made into the market’s Maginot Line, separating good times from bad times.
A low VIX seems to suggest stocks are on the verge of another epic advance—and they might be. A low VIX might also suggest the market is on the verge of an epic decline—and it might be. After all, VIX is popularly known as the fear gauge, and if it is low it means investors are not afraid, or maybe that they are complacent. We have been bullish in this column for some time, and remain so, regardless of the VIX. VIX’s main drawback is that it provides only a 30-day snapshot of the expected movement of the Standard & Poor’s 500 Index. VIX is composed of a series of the index’s put and call options that expire in a month. But because VIX is expressed in a single number, like a stock, most people think they understand it. They rarely realize they are applying a stock-market mentality to the options market—and that is wrong and potentially dangerous, because it creates a false feeling of safety. The options market is far more multidimensional than the stock market. Right now, VIX futures prices are higher than VIX. When the market opened Thursday, May VIX futures were 3.13 points higher, and October VIX futures were 8.83 points higher. The premiums increase at later dates. Even the term structure (all the different expirations) of VIX options increases rather sharply in three to six months.
Picture a mountain. The fear gauge VIX is at the bottom. Term structure is the slope. Term structure is sloping higher, which is normal, but it is particularly steep these days, and that reflects growing fear of the stock market.
The market remains schizophrenic. One day, stock prices tumble because Standard & Poor’s questions the credit rating of the United States, and investors panic and sell and fret, and the front pages of many newspapers are apocalyptic. The next day stocks rise because of earnings, and everyone feels good again. The erratic patterns are rarely remarked upon. If you feel uber-bullish, stop and ruminate about your investment risk. If the smartest investors are hedging their stocks by selling calls that expire in three to six months, or buying defensive put options, what are you doing? Is it wise to do nothing if some ultra-sophisticated investors are nervous about the stock market?
When VIX is low, the prices of puts and calls that expire within three months are usually low. Many of the best investors buy options when volatility is low, and sell options when volatility is high. If you are worried about the near future, buy puts to protect your stocks. If you are bullish about the future, think of selling some stock and replacing your shares with calls. You could even sell bullish calls that expire in three to six months to take advantage of the fear premium in many stocks and indexes. You can use the stock-replacement or call selling strategies to withdraw your initial investment and limit your risk.
The key is playing with the house’s money, and not letting the house play with yours