In 1993 the Chicago Board Options Exchange introduced the CBOE Market Volatility Index, also known as the VIX, which measures the volatility of the U.S. equity market. It provides investors with up-to-the-minute market estimates of expected volatility by using real-time S&P 100 index option bid/ask quotes.

The VIX is calculated by averaging S&P 100 stock-index at-the-money put and call implied volatilities. The availability of the index enables investors to make more informed investment decisions. Going over the VIX's history along with the S&P 100, or OEX, you can see that all of the spikes in volatility accompanied market downturns and significant events that affected the market.

This history reveals a great deal about the relationship between the market and volatility. The VIX has a definite tendency to spike upward during market declines. For example, during the major market decline of October 1987, volatility reached very high levels. That spike was the result of the sharp one-day market correction in October. Volatility then declined steadily until late 1989.

Another sharp increase in volatility occurred in August and September 1990, when Iraq invaded Kuwait. In January 1991, volatility rose sharply again, just before the U.S.-led initiative known as Operation Desert Storm. Another peak in volatility reflected the market's downturn, which occurred one month before the U.S. presidential election in November 1992.

The tendency of market volatility to expand during market downturns is clear from this historical account. This relationship is the subject of numerous studies in the options market. Perhaps the best way to understand the relationship between volatility and market declines is to look at the options market from a put perspective.

A put is the option market's equivalent of an insurance policy. An investor may purchase a put to insure a sale price for the underlying asset. The seller of a put may be viewed as the equivalent of an insurance underwriter. The put-writer accepts a premium in return for accepting a risk, which in this case is ownership of the underlying asset. In the insurance business, premiums rise after significant negative events. In the options business, market volatility, the critical factor in determining put-premium levels, increases in periods of market distress.

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.

By

Jeff Neal, staff writer and options strategist at

Optionetics.com.