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.

Back in June and early July, I devoted three separate Technical Tuesday columns to the subject of volatility. I did so because I felt that an understanding of volatility could enhance your trading and investment results. 

However, I was spurred to write those columns by the market sell-off that had just commenced. If you recall, when stocks began to slump, many in the financial press were suddenly throwing the word “volatility” around in their daily commentary like they really knew what they were talking about. Since I view the great majority of utterances emanating from the members of the financial fourth estate with a jaundiced eye, my first reaction was to disregard their mutterings as the latest round of mindless blather.

But one thing caused me to rethink my initial reaction. You see, I was aware that the financial pundits were right this time — volatility had increased. And the pundits were right to be talking about it. So, I decided to pen those three columns in the hopes that you could increase your knowledge of volatility and use that knowledge to your advantage when making your trading and investment decisions. 

Well, now that you faithful Sleuth readers are experts on the subject of volatility, I thought it would be a good idea today to look back and see whether that knowledge of volatility has been helpful in interpreting recent market conditions. Also, I thought it would be a good time to apply that knowledge of volatility to see if we can pick up any clues about the present state of affairs in the equities world.

Now, I haven’t heard many of Wall Street’s purveyors of news and commentary wax eloquently on the subject of volatility lately. But that doesn’t mean we shouldn’t be mindful of it. We should. In fact, since the talk about volatility has died down, the VIX has told quite a story.

Why do I say that? If you take a look at a daily chart of the VIX, you will notice that it has traded almost perfectly opposite to the S&P 500 Index over the past three months. And that’s exactly what it’s supposed to do. 

If you recall, I said in my July 11 Sleuth column that “[I]f you look back at the historical price action of the VIX you will see that the index has typically been negatively correlated with the S&P 500. By that I mean a rising VIX Index has generally occurred during times when the S&P 500 is falling and vice versa.”

To be completely accurate, the VIX did not bottom concurrently with the top in the S&P 500 in early May. Actually, the VIX registered its low of 9.88 back on July 20, 2005. It then registered higher lows of 10.15 and 10.53 on December 16, 2005 and March 14, 2006, respectively. However, in retrospect we can see those higher lows were warning signs that a significant top in the S&P 500 lay not too far in the future. 

That’s particularly evident when you consider those two higher lows were made during the same time frame that the VIX put in consecutive lower highs — in October 2005 and February 2006. Thus, as the S&P 500 was traveling upwards toward its May 8, 2006 peak of 1326.70 — with one major pullback between August and October 2005 — the VIX was oscillating in an ever-tighter range. That was another hint that volatility was set to increase and the trading pattern of the venerable S&P 500 was primed to undergo a sea of change.

But what has transpired in both the S&P 500 and the VIX since May is much more interesting — and potentially every bit as valuable. Let’s look at what’s taken place…

The VIX notched its last minor intra-day low of 11.18 on May 5 — just one trading day before the S&P 500 topped out. Then, as the S&P 500 turned south and dropped 6.1% over the next 12 trading days, the VIX soared, reaching an intra-day high of 19.87 on May 24 — the same day the S&P 500 made its initial low. Incidentally, it was that spike in volatility that sparked the comments by the members of the financial chattering classes.

But it didn’t stop there. After a brief respite that saw the VIX briefly poke its nose back below 14 on June 2, this important volatility gauge leaped another 71% over the next week-and-a-half, closing on June 13 at 23.81. That marked the highest level the VIX had reached since April 11, 2003. More importantly, however, that peak in the VIX occurred just one day before the S&P 500 registered an important low.

Over the next few weeks, the VIX alternately put in a new post-May 5 low of 12.74 on June 30 and a subsequent swing to go up to a high of 19.58 on July 18. The June 30 VIX reading was recorded just one trading session prior to the S&P 500 registering an important high on July 3, while the July 18 reading coincided exactly with the next S&P 500 swing low. 

After registering that July 18 high, the VIX has once again moved lower — coinciding with the S&P 500’s late-July/early-August rally. While I find the VIX to be a valuable tool in assessing market trends and trend changes, its accuracy over the past three months in pinpointing turning points has been downright remarkable. 

OK, so where are we now? As I said, the VIX’s recent decline off its July 18 high has corresponded with a rise in the S&P 500. Nevertheless, volatility — as measured by the VIX — remains higher than it was at its 11.18 May 5 low. Unless the VIX can take out that same low on a closing basis, volatility must be considered to be trading in an upward trend — a negative piece of evidence concerning the short-term prospects for that widely followed stock market benchmark.

Just as important, a close by the VIX above its recent high of 19.58 would likely be accompanied by lower stock prices. Not only that, but such an increase in volatility would confirm the current uptrend in the VIX — and greatly increase the chances of the S&P 500 testing its June 14 and July 18 lows.

So, if you want to know if we’re headed for more serious downside market action, or if the coast is clear, keep an eye on the VIX. It’ll keep you on track. Just ask the financial pundits.

Trade well,

Mark Bail
August 08, 2006

Recent Moves in the VIX was originally featured in the Penny Sleuth.