Q&A
Explore Your Options
| Got a question about options? Tom Gentile
is the chief options strategist at Optionetics (www.optionetics.com), an
education and publishing firm dedicated to teaching investors how to minimize
their risk while maximizing profits using options. To submit a question,
post it on the STOCKS & COMMODITIES website at Message-Boards.
Answers will be posted there, and selected questions will appear in future
issues of S&C. |
Tom Gentile of Optionetics
|
VOLATILITY INDEX
Tom, I have heard of using the volatility index (VIX) as a way
of predicting overall market movement. Can you explain this to me, along
with some ideas on how to trade the VIX in the markets? - Fred M.
The VIX is a measure of nervousness among traders. The VIX is a chartable
indicator, and when it drops to 20% or lower, it means that the markets
are calm and have a positive outlook for the future. A high VIX, above
35%, means that the markets are nervous, indicating the future outlook
is uncertain. They say among traders that when the VIX is high, it's time
to buy, and when the VIX is low, it's time to go. This is a sentiment statement
that means you want to move opposite to the crowd. The idea is that when
everything looks too good to be true (low VIX), trouble is likely to come.
It also means when panic sets in (high VIX), it could be the best time
to buy.
Now it's hard to say how high is "high," but I do know that
when we get to a low below 20%, it usually indicates that a correction
in the market is due. Over the last five years as I have tracked the VIX,
the market has corrected within 30?60 days after the VIX goes below 20%.
Figure 1 is a chart of the Dow Jones Industrial Average (DJIA) and the
VIX. Arrows indicate the times when the VIX dropped below 20%. The additional
table (Figure 2) shows exactly what happened to the markets within the
30 days following the VIX dropping to 20%.
FIGURE 1: THE VOLATILITY INDEX AND THE DJIA
FIGURE 2: What happens in the month following a VIX drop below
20?
According to the table, four of the last five times the VIX fell below
20% resulted in a market correction 30 days later. There was one time the
markets actually moved higher, but no system is 100% correct. One way to
trade the VIX is simply to buy index put options whenever the VIX trades
below 20%. When the VIX is this low, options in general are cheap, making
it a safe bet to buy them. Because the markets generally move within the
next 30-60 days, I like options with at least 60 days to expiration. This
way, you are able to stay in the trade for the duration of the move.
There is little chance we will see a low VIX in the near future. So
far this fall the US stock market has been more volatile than ever before.
It is rare to see the VIX, also known as the market's fear gauge, remain
above 40% for a prolonged period of time, but as of this writing [September
2002], the VIX has been trading above 40% for nearly a month - extraordinarily
high.
BUYING CALLS
I heard somewhere that the best time to buy calls is near the
end of October, and the best time to buy puts is just after April. Have
you heard of this? - Pete T.
I have researched each of these statements, looking at buying index
call options near the end of October and buying index put options after
April 15 (tax day). The markets often rise after October, mainly due to
the lifting of the downward pressure from the month before. And yes, I
have also seen that the markets typically fall off during April as a correction.
Now the real question is, which one offers a better trade? While October
through December may look like a great trade to the upside, the problem
is that the options premiums are usually quite high after a drop in the
markets. If October was a big down month, then you would expect to pay
two or three times more in option premiums than in September, due to the
volatility spike. In a rising market, however, options premiums are usually
low, meaning that you are getting a better price for your put options if
you intend to fade the market to the downside. Historically, more money
is made buying outright put options in a correction than buying outright
call options in a bounce.
Return to November 2002 Contents
Originally published in the November 2002 issue of Technical
Analysis of STOCKS & COMMODITIES magazine. All rights reserved. ©
Copyright 2002, Technical Analysis, Inc.
