By: Chris Rowe — August 27, 2019
There are many popular and simple ways that options are used to gauge the sentiment of investors.
They are used the same way that the Investors Intelligence readings are used, as contrary indicators, when at extreme levels.
But there is only one that I want to focus on here as it is extremely reliable.
The CBOE (Chicago Board Options Exchange) Volatility Index – aka “the VIX”
This indicator, known as the "investor fear gauge", starts to rise during times of high stock market stress, and falls as investors become complacent.
Before I even begin, let me stress that this indicator should only be used for finding stock market bottoms (not tops).
This indicator is free of charge, because as long as you can access stock quotes, you can access the VIX. The way to access the quote or chart may vary depending on what quote system you use, but you can always get a quick snapshot simply by Googling "VIX".
The VIX is based on options on the S&P 500. There are several other volatility indices such as VXD, which is based on the Dow Jones Industrial Average, and VXN, which is based on the NASDAQ, but there is no need for you to follow all of them. Here, we’ll focus only on the VIX (based on the S&P 500).
The VIX is an implied volatility index that measures the markets’ expectation of 30-day S&P 500 volatility implicit in the prices of near-term S&P 500 options.
Specifically, the VIX uses nearby and second-to-nearby options with at least eight days left to expiration... and then weights them to yield a constant 30-day measure of the expected volatility of the S&P 500 index. VIX is quoted in percentage points just like the standard deviation rate of return.
I’ll put this as simply as I possibly can without explaining details on the way that option contracts are priced.
Stock options are largely used as a tool to hedge stock positions or in place of a stock position because when used correctly, options tend to expose you to less risk.
When option traders determine the fair price for a given option contract, they consider the price of the underlying stock or index (in this case, the S&P 500)... the time left before expiration... dividends... interest rates... and the historic volatility. These are all factors (variables) that have already been determined.
The last factor that traders consider when determining what they’re willing to pay for an option is the “implied volatility” (expected volatility).
What’s implied volatility?
Let’s say that “stock option A” had the exact same characteristics as “stock option B”... except for implied volatility.
Stock B on the other hand is expecting a major court decision that might have a huge impact on the price of its stock.
If you compare option contracts on “Stock A” and “Stock B” that both have the same exact characteristics (such as strike price and expiration day,) here’s what it would probably look like:
“Stock option A” might trade at $2.20 while “Stock option B” might trade at $4.00.
As you can see, because investors expect a larger move on stock B, they are willing to pay more for the options.
Back to the VIX
Remember: The VIX is based on options on the S&P 500.
Investors are willing to pay more for options when they’re experiencing a high level of fear. Investors buy Put options in order to protect their existing positions or to bet on the market trading lower.
They buy Call options to speculate on a rebound or simply because if the market continues to trade lower, the downside risk on a Call option is lower than that of a stock.
Therefore, when investors become more fearful of future market conditions, they are willing to pay more for options than usual. When the prices for options on the S&P are higher (and the VIX is higher), it means that investors expect more volatility.
When the VIX is at levels greater than 30 (which is considered high), it is associated with a large amount of volatility due to investor fear or uncertainty.
Conventional Wisdom vs. Chris’ Advice
What people are usually trained to believe, and what I used to teach people, is to look for Buy signals when the VIX is above 30. Of course, the fact still remains that when the VIX is over 30, the market is probably at very low levels.
But if (to use a historical example) you had waited for 30 to buy after the market recovered in 2003- 2004, you would have missed years of profits in a huge bull market.
Experience has shown that static interpretations of the VIX are an incorrect approach.
A dynamic approach is the best way to play it.
In other words, a better way to use the VIX is to watch for peaks in the chart.
When you are looking for multi-year lows, peaks above 30 make sense, but when looking for dips in a bull market, peaks above 20 make sense, too.
The best way to play it is to watch very closely for the VIX to start moving lower after its high peak.
I like to take AT LEAST partial (bullish) positions when a peak seems to be topping out and at times the VIX moves even higher, and I like to take a larger bullish position when the next peak seems to be topping. This happens very fast. Fortunately, it’s easy to see that the VIX is moving to these high levels. It’s the peak that happens fast, so you should have time to mentally prepare to act swiftly.
When the VIX is over 40, it means that there is a TREMENDOUS amount of fear in the market. I mean, people think that the sky is falling, and the world is coming to an end.
That, my friends, is a HUGE indicator that we have hit a bottom, and you should drop everything and BUY.
Again, wait until the VIX has peaked and starts to move lower. You don’t have to buy the absolute bottom. It’s more important to make sure that you aren’t catching a falling dagger.