Upbeat music plays throughout.
Narrator: Implied volatility levels can tell you a lot about the market. One of the most useful is the market sentiment, or to put it another way, whether traders are feeling more bullish or bearish. There's one important index that can help you identify current implied volatility levels—it's called the VIX®.
On-screen text: Index | VIX, Cboe Volatility Index®
Narrator: Sometimes it's referred to as the “fear” index. It's a helpful tool that allows investors to determine market sentiment. It can also be used by option traders to help make trading decisions. Let me show you how it works.
On-screen text: Disclosure: The example used is for illustrative purposes only. Not a recommendation of any security or strategy.
Narrator: First, let's discuss how the VIX works.
To do this, you need to understand the relationship between stock prices and implied volatility. When stock prices are expected to make a big move up or down, investors typically purchase more options. For example, suppose the market has been falling for a few days. This would cause many investors to become protective of their stock positions.
As a result, many of these investors might buy options as a form of protection. This increase in demand suggests there's more uncertainty in the market. This leads to higher implied volatility levels, which helps market makers price in this higher level of uncertainty.
Investors look to the Cboe Market Volatility Index, or the VIX, to determine the implied volatility levels for the overall market. This index tracks the implied volatility for the S&P 500® Index options. If the VIX is rising, demand for options is increasing and therefore becoming more expensive. If the VIX is falling, there's less demand and options prices tend to fall.
To understand this relationship, put yourself in the shoes of a market maker. As a market maker, you sell a product, which grows in value if certain situations occur. So, if you're sitting at your desk one day, and you start seeing more and more orders coming in for an option, you might think these traders know something you don't, and the markets will make a big move soon. So, you'd likely raise prices to price in this uncertainty.
These higher prices also have another effect—they attract option sellers. Now, for example, suppose the level of uncertainty in the market increases, and options premiums are now higher. Traders who felt the volatility was too high and would soon fall would begin selling options. And this is exactly what market makers want—more order flow. If more option sellers appear, implied volatility levels will likely begin to fall.
Let's look at some examples of where the VIX spiked and what might've caused it.
Animation: A graph with a horizontal axis for months listing October, November, December, January, and February appears on the screen. The vertical axis lists VIX numbers increasing to 40-point increments, starting at 1840 and ending at 2021. A blue graph line rises and then zigzags vertically to show the SPX trajectory.
On-screen text: Disclosure: The example used is for illustrative purposes only. Past performance is not indicative of future results.
Narrator: From October 2014 to January 2015, the S&P 500® had three major sell-offs in October, December, and January. Now, let's look at the VIX. Notice how it spikes with each sell-off. These spikes indicate a rise in uncertainty in the markets.
Animation: A yellow graph line appears on the graph tracking the trajectory of the VIX in yearly increments between 2005 and 2013.
Narrator: Now, let's look back at the 2008 bear market—a moment of profound fear. Here we see the VIX skyrocketed. This is impressive. However, watch what happens when I draw a price line at the 49 mark.
Animation: A dotted line is drawn through the horizontal center of the graph and bisects the places where the VIX line and the SPX line meet.
Narrator: When the VIX is at this level, it tends to correspond to a bottom in the market. Obviously, 2008 is an outlier. But if you were an option seller, you can imagine how high prices would've been.
In fact, recognizing high implied volatility is one way market makers create their positions. Just like with stocks, you can buy low and sell high with volatility. Or sell high and buy low. Accordingly, market makers often sell options when implied volatility is high in an attempt to allow time decay to create their profits.
Put it in your calendar today to make watching the VIX part of your trading routine.
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