The VIX -- or the Chicago Board Options Exchange ( CBOE ) Volatility Index -- is one of the most commonly tracked measures of U.S. stock market volatility. It gives us insight into investors' expectations for short-term volatility in the stock market. But how does the VIX impact your options trading approach? To answer that question and more, I spoke with Schaeffer's Senior Trading Analyst Bryan Sapp to discuss all things VIX.
Why do they call the VIX the stock market's "fear gauge"?
BS: The VIX is an index value that is derived from underlying demand for S&P 500 ( SPX ) put options. That is, when demand for put options on the S&P 500 is relatively higher, the VIX will spike. This generally occurs during market downturns, as investors will oftentimes buy put option protection when the market is on the decline, as opposed to strong bull markets.
What do you make of the record streak of VIX closes below 10?
BS: The recent streak of low VIX closes is both amazing and historic. Given that we're currently in a market of extremely low volatility, it makes sense that investors aren't very fearful. Even though the VIX is currently at historic lows, in a sense, it is still overpriced on a relative basis. This is because realized volatility on the SPX has been hovering near 6% to 7% for most of the year. So, even though the VIX is at historic lows, it makes sense given the overall lack of volatility in the market.
How does a low VIX impact your options trading approach?
BS: A low VIX will be observed most often in trending bull markets. Stocks will generally make small positive moves on a day-to-day basis, as opposed to two-way swings that have more price movement. As a result, it generally makes sense to buy options with more time until expiration, as these options are cheap, and the longer duration will allow a trader to take advantage of the strong market trend in place. The recent winners in some of our options recommendation services, such as PowerTrend and Weekend Trader , provides a good example of how longer-dated options can perform really well in an environment like this.
How do you find good premium-selling opportunities in a low-VIX environment?
BS: At Schaeffer's, we generally like to sell relatively high option premium and buy relatively cheap option premium. It can be difficult to find lucrative premium-selling opportunities in this environment, but there are always market events that will cause a spike in implied volatilities. As a result, a trader looking to sell premium can focus on stocks that have earnings, or macro assets around big economic events. One particular strategy that we've had success with is selling premium on stocks immediately after they report earnings. The event risk will often disappear or reduce after the news, but options will continue to hold some excess premium, relative to the inherent risk.
Is there anything else you'd like to add about the VIX?
BS: The VIX is really interesting, in that it can virtually be in a coma for months upon end -- but if and when there's an event that changes the market landscape, directional action can be extremely violent to the upside. This is a good indicator of reactivity by investors, as things can change in an instant. Attempting to time these spikes has been a fool's game lately, as VIX call buying has been very popular, but most of those options end up expiring worthless. However, that isn't to say that there can't be a prolonged volatility spike looming. There would need to be a significant shift in the current macroeconomic landscape or a major geopolitical event for any such spike to persist.