Practical Use of the VIX

10/24/2011 3:30 pm EST

Focus: OPTIONS

Dan Passarelli

Founder, Market Taker Mentoring, LLC

The Volatility Index (VIX) is widely known as the "fear index," but Dan Passarelli tells how option traders can get helpful signals from the VIX while also assessing recent VIX action.

You may have heard that the VIX is the gauge of fear in the market, but how do you really use that to make good trading decisions?

Today’s guest is Dan Passarelli, who’s here to talk about that. So Dan, first of all, what does the VIX measure?

The VIX specifically measures the implied volatility of the options on the SPX, which of course is the index that represents the S&P 500.

Alright, so if I’m watching VIX on a daily basis, as a lot of traders are these days, how does it help me make better trading decisions?

Well whenever you trade options, you’re trading implied volatility. Implied volatility measures how cheap or expensive the options are. So if you’re an options trader, that must be one of the indexes you’re watching.

If all you do is trade stocks, what’s one of the first things that you’re going to look at every morning? You’re going to look at the Dow Jones or the S&P 500, or probably both.

If you’re trading options, the profitability of your option positions if affected by the market as a whole, and of course, the individual stocks, but you also care about how expensive or cheap the options are. So therefore, even if you’re not trading the S&P 500, if you’re trading an individual stock, you still look at the S&P 500 as just a gauge to get your bearings on the price of stocks.

You look at the VIX to get your bearings on the volatility of the market collectively in this similar fashion.

Let’s talk more recently about what’s going on in the market. We’ve seen quite a bit of price action coming down, and yet the VIX remained relatively flat. You would think that a lot of movement to the downside would increase that VIX as fear increased in the market, but we haven’t seen it. That’s concerning in itself, don’t you think?

It is. It’s really interesting to watch. That could indicate a little bit of complacency in the face of what is maybe a market scenario that doesn’t work with complacency, which could be a little bit of a bear signal.

So do you feel like we’re headed lower here into the rest of 2011?

I don’t think we’re heading too much higher. I mean, we’ve been in a little bit of a channel. It’s been a very volatile channel, and right now we’re kind of at the cusp of perhaps breaking through.

I think there might be a little bit of room to the downside, but I think ultimately I’d be surprised if we move more than 4% or 5% from where we are now either way.

So knowing that we might be in a range and it may only be 4% or 5%, give us an idea of a trade—a spread or something that we could profit from if it doesn’t go very far either way.

Well because implied volatility is higher than it historically is—although arguably maybe not as high as perhaps it should be—a strategy that has been working well if you’ve been able to time it well is to sell put credit spreads when the market is at its lows, and then when it reverses course and goes back to the top of this channel that we’ve been in, then leg into the other side of what we’d call an iron condor and sell the call credit spread.

Alright talk about what the put credit spread is.

Sure. A put credit spread is when I sell a put that’s out of the money and I buy a lower-strike put for protection. Your potential profitability comes from that short put, but that’s also where your risk comes from.

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