VIX Traps Traders Must Avoid

01/10/2012 9:00 am EST

Focus: OPTIONS

Joe Kinahan

Chief Market Strategist, TD Ameritrade

The VIX is a proven sentiment gauge, says Joe Kinahan, but that is only the first step in executing winning trades. Here’s how to use the VIX as a component of an effective trade plan.

Over the last few years, the VIX has been important for traders to monitor, but what is it really and what should we be watching outside of the VIX?

Our guest today is Joe Kinahan to talk about that. So Joe, when we talk about the VIX, we talk about the VIX in context of other things. Why is it important to look outside of just the number? 

Well, first of all, the Volatility Index (VIX) is an important measure of the overall market, but it truly measures the options and the S&P 500 Index (SPX). Great guideline; however, if you’re going to trade an individual stock—let’s say, for example, you’re going to trade Apple (AAPL); what you really want to focus on is the volatilities in AAPL, because that’s truly where you’re making the trades. 

Again, the VIX is a nice guide; it’s like saying the S&P 500 is a guide for what the market is doing. Great to look at, but if I’m going to go buy Apple stock, I’m going to look at what Apple stock is doing, not just what the S&P 500 is doing.

You should start there and then drill down into the individual stocks or indices that you are going to trade, because in the end, what you care about is the relationships in there and what happens day to day or week to week in the individual products.

And there are instance where the market will rally or it will fall and the VIX really doesn’t move.  What’s going on there?

Well, it’s been interesting. We’ve enjoyed an incredible run-up here (as we speak) over the last few weeks as we talk about October 2011 and the early part of November 2011 on the S&P 500, and the overall market has gone higher. Interesting that the VIX has held on to this 30 level. It’s had a tough time breaking it. 

We see all of the problems between Greece and Italy that we have right here, so what it’s telling me is that although the market is doing well, and we would expect volatility to come out, but because of these overlying problems right now, there’s a lot of nervousness that we could still sell off. 

So it will be interesting to see what happens here as we head into the end of the year. If we continue to rally, can the VIX break the 30 level? That’s almost a magical level. I hate to use that word, but people say if we’re above 30, it’s time to be concerned, and if we can break 30, concerns are eased quite a bit.

NEXT: Is There a "Magic Number" for the VIX?

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And how does that number affect my trading decision overall? If the VIX is higher, am I long, or what does it mean?

What it really means is if the VIX is going to be above 30, you’re going to be in a higher-volatility environment, so if you buy options, you’re going to have to pay for them.

If you sell options—something as simple as a covered call—you can collect more money if you’re looking to enhance your returns a little bit.

But what it also means is you can go further away from the at-the-money options and get a premium that you are getting close to the money when volatility was low. So you can use it to your advantage as a trader and even as an individual investor in terms of enhancing your returns.

You hear that when volatility is high, I should be selling options because they’re expensive and I can be earning more money. Is there a number that you would say, “Over 35, I’m a seller of options; under 35, I’m a buyer?” 

Well, it goes back to your original question. I think you have to say not just the VIX, but overall, in the particular product you are trading, what do you think is the high-volatility number in there? Don’t just use the VIX as the sort of blanket for all products. 

But just as when the market goes up, the stocks that you trade (you hope) would go up. When the VIX goes higher, you would hope your volatility is going higher. When the VIX goes lower, you would hope the volatility of the products you trade would go lower.

Again, I would urge people to look at the individual products that you’re trading for the guideline, not just the VIX overall.

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