Using Option Greeks: Implied volatilty - part two | Volatility and the VIX

Follow us:

Twitter

RSS

Facebook

Using Option Greeks: Implied volatilty - part two

One of the most useful forms of implied volatility is the implied volatility index of the S&P 500 index options (SPX) usually known as the VIX. In a very real way the VIX reflects the fear of the general population of investors. This can be useful as a way to understand the strength of a given trend and as a way to forecast reversals in the market.

The VIX will show the relative risk or fear in the market compared to recent history. Traders will try to identify those points in the VIX when investor sentiment or fear has reached extremes. In the video I will show you several good examples of what to look for to find periods of excessive fear and bearishness as well as too much bullishness. These periods often lead to reversals in the market which is a good time to reduce market exposure and begin looking for new opportunities.

As you can see, in the chart below, one of the things we look for when evaluating whether the VIX or investor sentiment is at extremes is whether or not the index is at the top or bottom of its channel. When the index is at resistance (the top of the channel,) we know that fear is at an extreme and we should be controlling any market exposure to the downside of the market very conservatively. It does not mean that we should automatically become bullish but, it does mean that we will act as prudently as possible to control the risk in any short positions or long puts.

Conversely, the market and traders in general can become over confident. Quite often a bounce off the lower side of the channel can indicate a significant shift in investor sentiment from low risk and growth to high risk and volatility. The channels on the VIX will shift over time but typically stay within a given range, such as the one shown on the chart, for several quarters to a few years.

Daily chart of the VIX or "CBOE Volatility Index"
vix

Need help understanding how to buy or sell calls? Click here for more information.

Do you have more questions about implied volatility? Ask us in the forums.

Charting provided by Metastock Professional - Click here for a free 30-day trial