As you can see from this graphic, from a high of 14,198 last October to 7,885 this October, the Dow has lost a staggering 6,313 points. That translates to a whopping 44% loss and a boatload of pain for just about everyone out there.

It gets worse. For the Dow to recover from its low of 7,885 to its high of 14,198 — in other words, to regain all of its recent losses — it would have to book an 80% gain. That’s nearly twice the size of its original loss and a mammoth amount of upside action.

But if you think now’s the time to throw in the towel, think again: While stock owners are taking it on the chin, option players are faring much, much better. Take a look…

This is a chart of the VIX index from the Chicago Board Options Exchange, the granddaddy of all options exchanges. Without getting into a bunch of mathematical jargon, the VIX measures the volatility — or expected price changes — in the broader U.S. stock market. And because volatility leads to uncertainty and uncertainty leads to fear, the VIX is sometimes called the “investor fear gauge.”

As you can see from the chart, the VIX is through the roof. In fact, at a level of 76, the VIX over twice the threshold of 30, a key level that indicates skyrocketing fear and uncertainty. And this is good for options traders for two big reasons…

First, high levels of volatility and uncertainty mean the time value part of your options’ prices are likely headed way, way up. Why? Because with time comes uncertainty. And as an options owner you’ll be compensated — often handsomely — for bearing that uncertainty.

But that’s not all: With the VIX at these nosebleed levels, market sentiment is so uncertain, so negative that there’s no way a recovery can be too far off. In other words, a high VIX level can indicate a contrarian move in the market is very, very likely. And in our case, that contrarian move would be to the upside.

Best wishes,

Wayne Burritt
November 4, 2008

P.S.: I started Easy Money Options to open the lucrative options world up to everyone. It doesn’t matter if you never traded a single option in your life or you’re a seasoned pro, my service is right for you.

How to Hedge Your Penny Stock Plays was originally featured in the Penny Sleuth.

As I mentioned in recent Technical Tuesday columns, my essays on volatility and the VIX index have generated quite a bit of interest. On August 22, I addressed a comment and question from one Sleuther regarding his experience trading the VIX option. Since then, we have received other correspondence. So, I thought I would use today’s column to comment on three more e-mails on this stimulating subject.

As I’ve said before, my purpose in writing this Technical Tuesday column is to bring to your attention some of the myriad ways to employ technical analysis to improve your trading or investment results. One way I’ve tried to do this is by describing some of my favorite technical indicators. At other times, I’ve used some of those indicators to analyze one or two broad-based market indexes. I’ve also written about seasonal market patterns, sector relative strength, and volatility. In each article, I’ve tried to discuss issues I thought would be of value to you.

However, I do not presume to know exactly what’s on your mind. But if you take the time to shoot us an e-mail, I figure that what you’re writing about is probably important to a number of other Sleuthers as well. So, for those of you who have e-mailed us, thanks for writing in.

Now, here are some more e-mails on volatility, along with my comments. I hope you find these enlightening. Let’s start with an easy one:

Q: “Do not understand ‘VIX.’ Please explain. Thanks.”

A: VIX stands for the Chicago Board Options Exchange Volatility Index. It is a measurement of the expected volatility (up-and-down movement) over the next 30 days in the S&P 500 Index. The VIX Index is constructed from near-the-money puts and calls on the S&P 500 Index in the two months closest to expiration. For more information on the VIX Index, take a look at my earlier Sleuth columns on the subject:

June 20, 2006

July 11, 2006

August 8, 2006

August 22, 2006

Q: “Dear Mark,

“I have to agree with the Sleuther about the value of the VIX options. In May I bought the 12.50 Nov. calls for my own account and the VIX. Subsequently spiked to the low 20′s. The intrinsic value was $8.00+, however the best ask price was around $4.00. Annoyed at the poor pricing, I sold that position and just watch the VIX as a measure of general market complacency.”

A: The Sleuther is referring to the e-mail I wrote about in my August 22 Sleuth article. If you missed that issue, or would like a refresher, you can use the link above.

As I said on August 22, my primary purpose in discussing the VIX Index was not so much to furnish you with a pure volatility trading play. Rather, I wanted you to have at your disposal a widely followed volatility metric to use as an additional technical indicator to make better trading and investment decisions. I, like the Sleuther in the above e-mail, typically monitor the VIX to gauge the overall level of fear or complacency in the market at any particular time, in light of the S&P 500’s recent price behavior. But as I have pointed out previously, do not underestimate the VIX’s ability to forecast, or at least confirm, market turning points.

Nevertheless, as a trader I understand that sometimes you have a strong conviction about something other than the direction of a stock, ETF, or market index. And if you have a strong conviction about volatility, you want the opportunity to capture a profit if your forecast is accurate. So, I understand the annoyance the Sleuther experienced in trading the VIX option.

The problem this Sleuther faced was in buying a VIX option with six months until maturity. The VIX Index is based upon options with an average of 30 days until expiration. Although the VIX is constantly updated, options with six months until expiration are not in synch with the time frame underlying the Index. That divergence in timeframes, plus the added guesswork involved in attempting to project volatility levels into the distant future, is what probably caused those options to fail to attract sufficient trading interest. A lack of trading interest results in a lack of liquidity and poor option pricing.

The bottom line is if you are interested in making a pure play on volatility, the simplest way is to trade VIX options closer to expiration with a large amount of open interest. You can also trade the VIX futures or create a strategy combining VIX futures and options. Otherwise, just use the VIX index as another technical tool. Don’t worry, it’s a good one.

Q: “I traded the VIX options based on Strategic Investment’s recommendation. When the options did not move directly with the VIX price ($12 in the money trading for half that) I researched and found out that they are European options so they do not move directly with the price unless you are in the near month. Dan Amoss recommended selling them once I brought this question up. I have kept my calls since I am looking for a higher VIX this fall.

“I could have traded even the farther out options a couple of times for profit rather than hold them but not near the profit the actual VIX price reflected.

“It appears that you need to either trade close months on a short term basis or buy longer term trying to anticipate when a market bottom might occur (for calls).

“As an example the 25.5 calls for Sep went from $3.50 at the beginning of August to $1.60 this week, while the Feb 07 12.5 calls stayed between $4.30 and $4.70. The Sep 15 puts went from $1.20 to $2.15 while the Feb 07 15 puts stayed between $1.80 and $2.00.

“I don’t understand why they would issue European style options but they did.”

A: Given the way longer-dated VIX options are priced, it’s not advisable to trade in and out of them. Due to the inefficient way they’re priced, over the long run the spreads between the bid and ask will just kill you. If you have a strong conviction about the long-term trend in volatility, you can buy a longer-dated VIX option. Just be prepared to hold it until close to expiration when the option will be much more liquid and be priced better.

If you don’t want to put all your eggs in one basket, or if you want to hedge yourself, you can trade around a longer-term VIX option with shorter-term ones. Or, as I said earlier, you could employ a strategy combining VIX options and VIX futures. But if you follow this last approach, you might first wish to consult a knowledgeable broker.

It’s true that VIX options are “European style,” meaning they can only be exercised on the settlement date. By contrast, most stock, ETF, and index options are “American style” options, meaning they can be exercised prior to settlement.

I contacted the Chicago Board Options Exchange (CBOE) to find out why VIX options trade European style. I was told since the VIX option price is based upon the price of the VIX futures (it’s one-tenth the value), limiting the opportunity to exercise the options until settlement makes it easier to settle the options, especially when there is a spike in volatility. I was also told the VIX option premiums would be more expensive if they traded American style.

One last reason the VIX options trade European-style is for purposes of consistency. Keep in mind the price of the VIX Index is based on options on the S&P 500 Index. Those S&P 500 Index options also trade European style.

There is also one last point to consider. An in-the-money VIX option may not fully reflect its intrinsic value, when measured against the current price of the VIX, because the price of the option is based upon the VIX futures contract, rather than the VIX Index.

Thanks for your questions and comments on the VIX. If you have more queries on this subject, just e-mail us at thesleuth@agorafinancial.com. Although I can’t respond directly to you, I may just include your thoughts in a future Technical Tuesday column. And if I don’t know the answer to your question, or want to get a further take on the point you raise, I might go to the horse’s mouth and get the answer from the CBOE.

In my next article, I’ll discuss another measure of volatility. I hope you enjoyed this one.

Trade well,

Mark Bail
September 19, 2006

Sleuth Readers Speak on Volatility was originally featured in the Penny Sleuth.

I’m pleased to report to you today that my recent columns on volatility and the VIX have generated some interest. That’s great!

After all, my purpose in authoring this column is to help you think about trading and investing in a different way than you may have done previously. In applying some of the concepts I discuss and in using certain indicators I’ve described, you can search for additional ways to let your profits run, protect your capital, and uncover new trading and investing opportunities.

Along these lines, let me share with you an e-mail I recently received from one of you Sleuthers:

“I would be interested in reading an article about how to buy the VIX for a long-term holding. I realize the VIX is more about a 30-day timeframe, but I noticed earlier this year that the CBOE announced the ability to buy long dated options. The problem is they don’t behave like I originally thought.

“A call to my broker prior to a purchase wasn’t of much help either. So I dabbled with a single option to see how things would work out. I made money, but I don’t like how it works. I realize SPY is another choice, but is there a better approach for buying the VIX and holding for a year or two?”

This Sleuther is correct. If you are interested in trading or “investing” in volatility through the VIX, you can avail yourself of options based on the indexes that trade on the Chicago Board Options Exchange (CBOE). Those options first began trading earlier this year.

I do not know what this Sleuther was referring to in commenting on how the option behaved. But if you are interested in buying or selling options on the VIX, a number of the strike prices have a large amount of open interest. Therefore, liquidity should not be a concern. So, if you are looking for a directional play on volatility — and particularly on volatility levels on the S&P 500 — you can consider the new VIX options.

Now, this Sleuther is also correct in that the VIX is calculated based upon a 30-day timeframe. So, even though there are longer-dated options available for trading the VIX, the intrinsic value of those options are based upon the VIX index itself, which is calculated through the use of options with an average timeframe of 30 days. But keep in mind that the VIX’s 30-day timeframe is continually updated. That updating does tend to mitigate the short-term nature of the VIX’s value, and enables you to consider volatility in a longer timeframe if you have a conviction regarding the long-term direction of volatility.

I should make one other point about the 30-day timeframe: Because of this timeframe, the expiration and settlement rules regarding the VIX options are different from most other equity options whose underlying security is an individual stock or an exchange traded fund (ETF).

Although I am oversimplifying things a bit, most options whose underlying asset trades on the American Stock Exchange (or any other exchange) conclude trading on the Friday of the expiration week. Due to the 30-day timeframe, the rules for the VIX options are a little different.

In order to conform the VIX’s 30-day time period within the confines of each month’s options expiration week, the VIX options conclude trading on a Tuesday and settle on a Wednesday. If the following options month is a four-week month, the VIX options will conclude trading and settle on the Tuesday and Wednesday prior to the Friday options expiration for most options. Conversely, if the following options month is a five-week month, the VIX options will conclude trading and settle on the Tuesday and Wednesday of the week following the Friday option expiration day for most options. 

Here are the expiration dates for the remainder of 2006, courtesy of the CBOE website, http://www.cboe.com/:

September 20, 2006

October 18, 2006

November 15, 2006

December 20, 2006

If you do not wish to trade options, you can take a look at the futures market. On March 26, 2004, the CBOE Futures Exchange (CFE) launched a futures contract based upon the value of the VIX. The VIX futures contract is based upon a price that is 10 times the expected value of the VIX Index. Thus, a November 2006 VIX futures contract with a value of 132.00 implies a forward VIX level in November of 13.20. You can find plenty of information and on the VIX futures contact at the CBOE website.

Trading a VIX futures contract with a distant expiration month would allow you to establish a position with a longer view regarding the direction of volatility. If you are concerned about being exposed to margin calls and the substantial risk inherent in futures trading, you could use the VIX options, in conjunction with a VIX futures position, to create a strategy that would lead to a profit if your directional call on volatility is correct, while limiting the risk in futures trading. You might wish to consult a knowledgeable futures broker to help you out.

But what if you don’t wish to get involved in futures? Is there any other way to establish a long-term position based upon your assessment of the direction of volatility?

The short answer is no, at least not at the present time. I say “not at the present time” because it seems as if a new ETF is created nearly every day that focuses on a specific area or facet of the stock market. I am not aware of any currently trading ETF that is based strictly on volatility. However, I wouldn’t be the slightest bit surprised to see one in the not too distant future.

Given the negative correlation between the movements in the VIX and the S&P 500 Index that I have pointed out in prior Sleuth columns, as the Sleuther mentioned earlier you can use the S&P 500 Depository Receipts (SPY:AMEX), a proxy for the S&P 500 Index, as a way to take a stand on volatility. However, that’s not a “pure play” on volatility, but rather a trade or investment you can initiate based upon the information you have gathered from monitoring the VIX.

And that was my purpose in discussing volatility in earlier essays. By keeping an eye on the market’s volatility levels, you have an additional weapon at your disposal when making trading and investment decisions. So, for now, unless you are willing to wade into the options or futures markets, think of the VIX as part of your technical arsenal. And when dealing with the financial markets, it never hurts to have as large an arsenal as possible at your disposal.

Trade well,

Mark Bail
August 22, 2006

Trading the VIX was originally featured in the Penny Sleuth.

If you’ve been listening to what passes for information from the financial press lately, you’ve been hearing the word “volatility” bandied about a lot.  You’ll here phrases like “volatility has increased” and “there’s more volatility in the market” filling the air — put there by scores of financial pundits who seem to be “in the know” about such things.

But if you’re new to investing — or just unfamiliar with some of the market jargon frequently spouted by the financial media — you may think that’s something you ought to know about.  Well, should you?  And more importantly, will becoming familiar with the concept of volatility help you improve your investment results?

The answer to those questions depends, to some degree, on what type of trader or investor you are.  If you trade actively, it certainly is important to know how volatility is affecting the market and what it means to your approach to trading.  And if you’re an options trader, an understanding of volatility is critical.  More on that later…

But what if you’re an investor?  Believe it or not, an understanding of volatility can assist you with your investment decisions.  By matching the amount of volatility you’re willing to accept as part of your investing program with your risk parameters and financial goals, you can tailor an investment portfolio that suits your temperament and comfort level.

How so?  Before I get ahead of myself, let’s define what “volatility” actually is.  Once we’ve defined the term, we can begin to look at a couple of ways that term is applied.  Then, you can begin to use your understanding of volatility — if you aren’t already — to create or enhance trading or investment strategies that take this critical element into account.

So, what is volatility?  Volatility is simply the relative rate at which the price of a security — be it a stock, market index, exchange traded fund, or option — moves up and down in price.  The way to mathematically determine a security’s volatility is to calculate the standardized standard deviation of a daily change in price of that security.

What?  If you’re not a mathematical person, don’t worry.  The essential point to remember is that when you are measuring the volatility of a security, you are comparing the movements of that security to the manner in which it has moved in the past.

The best way to understand volatility in reference to a security is to think of it in terms of price movement.  For example, if the price of a security moves up and down relatively quickly over a short period of time — or trades within a wide range over a short time frame — that security is said to have a high degree of volatility.  Conversely, a security that remains within a relatively narrow range is considered to have a low level of volatility.

One way investors can use volatility is by using it as a measure of the types of holdings they wish to own in their portfolios.  Why is this helpful?  Just think for a moment…

Let’s say you are an investor who is somewhat risk averse.  You want to own a diverse group of stocks in order to achieve an adequate rate of return, but you don’t want to take on undue risk.  Let’s assume you’ve already done one thing to lower your risk — diversified your holdings among different stocks, presumably in different industries.

But there’s something else you can do.  You can further limit your risk — or at least attempt to — by selecting stocks for your portfolio with a lower-than-average degree of volatility.

Why a lesser degree of volatility?  Because the smaller the range that a security trades within, or the more stable it is, the lesser degree of risk it is perceived to contain.

Now, generally the lesser risk you take, the smaller your profit potential.  But remember, we’re talking about a risk adverse investor here.

So, what’s average?  And how do you determine risk levels?  There’s a metric that answers both those questions.  And it’s one that measures volatility.

It’s called beta.  Beta is a quantitative measure of the volatility of a given security in relation to the S&P 500.  The movement of a stock over the past five years is evaluated against a 1% movement — up or down — in the S&P 500.  A stock with a beta of one is considered to have a level of volatility similar to the S&P 500.

The higher a stock’s beta, the more volatile — and hence the more risky — it is considered to be.  So, a stock with a beta greater than one is more volatile — and judged to contain more risk — than the S&P 500.  Conversely, a stock with a beta of less than one is considered to be more stable — i.e., less volatile or risky — than the overall market.

So, if you are an investor who is loath to take on a large degree of risk, in addition to buying several stocks — or a number of mutual funds — across different industries and asset classes, you could also look to fill up your portfolio with shares of companies that sport a beta of less than one.  In that way, in addition to diversifying your holdings, you would also ostensibly be limiting the degree of fluctuation in your investment account.

There are a myriad of other volatility measures as well.  As just one example, those of you who subscribe to MST Trader or one or more of Agora’s other options services are well aware of the importance that volatility plays in evaluating option premiums.  One important measure of determining the relative expensiveness of an options contract is its “implied volatility.”

Implied volatility is a measure of the value of the up-and-down movement of the underlying security — be it a stock, exchange traded fund (ETF), index, or futures contract — that is, imputed as part of the price of the option contract.  Factors that affect the implied volatility of an option include the price of the option, the option’s exercise price, the time remaining until the expiration date, the amount of any dividend to be paid on the underlying security, and the current risk-free rate of return.

As you can see, an understanding of volatility can aid both the trader and the investor.  And I’ve only scratched the surface on this subject.

Now, remember those market pundits I mentioned at the beginning of this column?  I don’t know how well they grasp the concept of volatility.  But I believe when they utter the word “volatility,” they’re referring to yet another metric — the Chicago Board Options Exchange (CBOE) Volatility Index, or VIX.  I’ll discuss that one next time.

Trade well,

Mark Bail
June 06, 2006

So What’s All This Buzz About Volatility? was originally featured in the Penny Sleuth.