Back to Basics: The Volatility Index

Increased volatility, the same factor that leads to an increase in put-premium levels, causes call-option premiums to increase at the same time. Thus, put-premium levels and call-premium levels move together, because they're both related to volatility. This relationship is critical to option strategists. High call premiums during periods of market distress are the opposite of what most investors expect.

A similar pattern would be observed if we looked at a chart of the implied volatility of an individual stock. When looking at a stock's implied volatility, remember that the number can vary from option to option within a family of options. It can also change for in-the-money or out-of-the-money types.

For this reason, most data services use a filtering process, or weight more heavily the more liquid at-the-money contracts. The most important consideration is that the service remains consistent in applying its rules. Remember also that as a stock's options become less liquid, the implied volatility becomes a volatile number. This would suggest that decisions based on implied volatility would be better for liquid issues than those less often traded. The bottom line is that the VIX is the central starting point when putting together option strategies.

Happy trading.