Why Watching the VIX When Hedging with Options Is Critical

09/28/2010 12:01 am EST

Focus: OPTIONS

Adam Warner

Author, Options Volatility Trading

The chart below shows ten-day historical volatility in AAPL over the past three months. To review, that’s the volatility of AAPL stock itself over the past ten trading sessions.


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Clearly, a couple outlier days can throw off a reading with such a small sample size. But, regardless of that, it gives a good window into very current stock volatility.

The chart below shows 30-day implied volatility of AAPL options in yellow. In other words, where the options expect to see AAPL stock volatility over the next 30 calendar days. It also shows 20-day historical volatility.


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What can you see here? Historical (realized) volatility has imploded. Both the ten- and 20-day readings sit at roughly five-month lows. Meanwhile, options themselves have bounced a bit, from 25 volatility to 30 volatility. Meanwhile, AAPL stock itself hits new, all-time highs just about every day. It’s an interesting little twist in the AAPL volatility story.

We are taught that volatility moves inverse to price. In fact, they have created a whole assembly line of trading VIX products with that concept in mind. But, as you can see, it doesn’t always work this way.

In fact, this pattern repeats itself quite often in “bubbly” sort of names. Initial new highs are greeted with a cheapening volatility curve. But, at some juncture, that reverses and volatility perks back up again.

What could be the cause? Perhaps stock replacement where traders and investors sitting on a winning stock position want to lock it in, while still maintaining upside, so they sell their stock and replace it with option calls. Others simply buy puts. Or maybe it’s simple nervousness once a name like AAPL has exploded beyond a trading range.

Whatever the reason, the flip side will happen too. At some point, AAPL will stop rising every day. And that down move may very well see volatility decline as well. The end result is that puts bought here may underperform, and the likely volatility move may offset some of the directional profits in the stock (pending the specifics of the trade of course).

The lesson: Any time you are considering using options to lock in profits on a stock trade, be sure to check the VIX to see how it is performing as well.

By Adam Warner of DailyOptionsReport.com.

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