Volatility Index Keeps Pointing in the Right Direction

It's funny how many different systems (indicators, news events, tarot cards) people use to determine what the stock market's future will hold.

Directional traders usually rely on the past to help predict future movement. When we're heading into the end of September, many traders are ready for the October shivers. Soothsayers stand poised and ready. Some watch money flow and are ready for gains based on the influx of money from institutional traders and money managers. Others look at the Alan Greenspan briefcase indicator, hoping the mere bulk of a bag holds a clue to the future. Still others look to the stars, waiting for Mercury to get out of retrograde.

Some of these methods are easier to translate into market movement than others. Astrology aside, one indicator I do find extremely helpful is the Chicago Board Options Exchange Volatility Index, known as the VIX.

VIX measures the speed of price movement on the S&P 100 index (OEX), and mainly tells traders the average premium levels of the OEX options traded. It can turn on a dime, going from low to high and back again, much like a stock.

Smart volatility traders will tell you that when VIX is high, it's time to buy, meaning they want to start buying index call options. When VIX trades at lofty levels, it tells me that options traders are betting on a continued drop in the markets, by purchasing puts and selling calls in full force. This almost always precedes a bottom in the market, since the short-term trader is usually wrong on market direction.

Smart traders also feel that when VIX is low, it's time to sell, meaning to buy puts as they feel a selloff of the markets is impending. When VIX is low, the market is usually heading higher, lulling traders into a sense of calm. I've usually found that a stormy market is not far behind a quiet VIX. The table below provides a recap of VIX peaks and valleys for 1999.

Date	VIX High or Low	Results
March 4, 1999	VIX High 30.98(Market Bottom)	150 point rise in 6 weeks
July 16, 1999	VIX Low 17.70(Market Top)	50 point drop in 4 weeks
August 5, 1999	VIX High 32.12(Market Bottom)	50 point rise in 4 weeks
October 15, 1999	VIX High 33.44 Market Bottom)	150 point rise in 10 weeks

Currently, VIX is very close to 30. That means that options in general are expensive. For buyers, that condition spells greater premium risk and less chance for reward. This is because the options on the OEX have a higher premium than normal, and if the VIX were to drop, premiums could drop with it. Even a directional move in your favor can be wiped out if you pay too much for the options. For options sellers, it spells the reverse. As options buyers and sellers, we have to choose our options carefully by looking not only at today's premiums, but at the historical ranges on options prices.

Looking at all optionable stocks, when comparing their at-the-money options prices with daily periods over the course of the year, nearly 50% are presently trading in the top 20% of their range. Only 7% of all optionable stocks are trading in the bottom 20% of their yearly range. The turmoil of the spring spawned this situation.

One thing that sticks out like a sore thumb is the lows that are below 20 and the high spikes above 30. If there's ever a time to be a buyer of options, this is the catalyst. For instance, if the VIX were to go from 30 to 20, option sellers would have a great chance of taking in premium faster as volatility declines.

If the VIX were to rise from 20 to 30, option buyers would have the odds stacked in their favor because as volatility rises, so does the time premium in the options they hold. With the second quarter earnings period coming up, coupled with the anxiety of another interest-rate hike, it's a good bet to start focusing attention on where VIX is currently trading.

VIX enables traders to gauge whether options are cheap or expensive. If VIX trades above 30, options are quite expensive and a selling strategy may prove better than simply buying options.

If VIX hits the low 20s again, buying options will offer greater opportunities than selling options. Either way, using VIX to interpret the markets offers traders consistent tools for gauging market timing and assessing option values.