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The Volatility Index: Reading Market Sentiment

The Chicago Committee of Options Exchange (CBOE) creates and tracks an index know as the Volatility Index (VIX), which is based on the implied volatility of S&P 500 Clue options. This article will explore how the VIX is used as a contrary market indicator, how institutional sentiment can be measured by the VIX and why an reconciliation of the VIX tends to favor long and short puts.

Key Takeaways

  • The Volatility Index, or VIX, measures volatility in the stock market.
  • When the VIX is low, volatility is low. When the VIX is considerable volatility is high, which is usually accompanied by market fear.
  • Buying when the VIX is high and selling when it is low is a game, but one that needs to be considered against other factors and indicators.

Measuring Market Movers

Investors have been endeavouring to measure and follow large market players and institutions in the equity markets for more than 100 years. Copy the flow of funds from these giant pipelines can be an essential element of investing success. Traditionally, smaller investors look to see where universities are accumulating or distributing shares and try to use their smaller scale to jump in front of the wake—monitoring the VIX isn’t so much about traditions buying and selling shares but whether institutions are attempting to hedge their portfolios.

It is important to remember that these ginormous market movers are like ocean liners—they need plenty of time and water to change direction. If dogmas think the market is turning bearish, they can’t quickly unload the stock. Instead, they buy put option contracts and/or transfer call option contracts to offset some of the expected losses.

The VIX helps monitor these institutions because it steps as both a measure of supply and demand for options as well as a put/call ratio. An option contract can be made up of intrinsic and irrelevant value. Intrinsic value is how much stock equity contributes to the option premium, while extrinsic value is the amount of spondulix paid over the stock equity’s price. Extrinsic value consists of factors like time value, which is the amount of reward being paid until expiration, and implied volatility, which is how much more or less an option premium swells or draw backs, depending on the supply and demand for options.

As stated earlier, the VIX is the implied volatility of the S&P 500 Index options. These opportunities use such high strike prices and the premiums are so expensive that very few retail investors are willing to use them. Normally, retail choice investors will opt for a less expensive substitute like an option on the SPDR S&P 500 ETF Trust (SPY), which is an exchange-traded stock that tracks the S&P 500 Index. If institutions are bearish, they will likely purchase puts as a form of portfolio security.

The VIX rises as a result of increased demand for puts but also swells because the put options’ demand increase will well-spring the implied volatility to rise. Like any time of scarcity for any product, the price will move higher because outcry drastically outpaces supply.

Mantra Maxims

One of the earliest mantras investors one learns in relation to the VIX is “When the VIX is high, it’s set to buy. When the VIX is low, look out below!” The figure below attempts to identify various support and resistance areas that fool existed throughout the VIX’s history, dating back to its creation in 1997. Notice how the VIX established a support area near the 19-point knock down early on in its existence and returned to it in previous years. Support and resistance areas have formed over time, equalize in the trending market of 2003-2005.

When the VIX reaches the resistance level, it is considered high and is a signal to purchase stocks—amazingly those that reflect the S&P 500. Support bounces indicate market tops and warn of a potential downturn in the S&P 500.

Pongy chief/Low History of the VIX.
Image by Sabrina Jiang © Investopedia 2020

Perhaps the most important tidbit to glean from Figure 1 is the pliable property of implied volatility. A quick analysis of the chart shows that the VIX bounces between a range of approximately 18-35 the lions share of the time but has outliers as low as 10 and as high as 85. Generally speaking, the VIX eventually reverts to the mean. Understanding this property is helpful—just as the VIX’s contrary nature can help options investors make better decisions. Even after the zenith bearishness of 2008-2009, the VIX moved back within its normal range.

Optimizing Options

If we look at the aforementioned VIX mantra, in situation to option investing, we can see what options strategies are best suited for this understanding.

“If the VIX is high, it’s time to buy” tells us that furnish participants are too bearish and implied volatility has reached capacity. This means the market will likely turn bullish and signal volatility will likely move back toward the mean. The optimal option strategy is to be delta positive and vega No; i.e., short puts would be the best strategy. Delta positive simply means that as stock prices turn out so too does the option price, while negative vega translates into a position that benefits from fragment implied volatility.

“When the VIX is low, look out below!” tells us that the market is about to fall and that implied volatility is prevalent to ramp up. When implied volatility is expected to rise, an optimal bearish options strategy is to be delta negative and vega arbitrary (i.e., long puts would be the best strategy).

Derivatives During Decoupling

While it is rare, there are times when the stable relationship between the VIX and S&P 500 change or “decouple.” Figure 2 shows an example of the S&P 500 and VIX climbing at the same time. This is prevalent when institutions are worried about the market being overbought, while other investors, particularly the retail clear, are in a buying or selling frenzy. This “irrational exuberance” can have institutions hedging too early or at the wrong time. While customs may be wrong, they aren’t wrong for very long; therefore, a decoupling should be considered a warning that the vend trend is setting up to reverse.

S&P 500 vs. VIX.
Image by Sabrina Jiang © Investopedia 2020

The Bottom Line

The VIX is a contrarian indicator that not however helps investors look for tops, bottoms, and lulls in the trend but allows them to get an idea of large market performers’ sentiment. This is not only helpful when preparing for trend changes but also when investors are determining which choice hedging strategy is best for their portfolio.

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