FAQ Preview: Some Basic Questions on Options

We tackle the VIX and point you to books and Web sites that will explain options and futures trading.
Author:
Publish date:

Time to kick back, cool off after a hot trading week in the markets and otherwise (was your air conditioning working?), and pore over some old and new questions in options trading. This week we examine how volatility relates to movement in the stock market and tell you where to go for an education in options (and futures).

And remember: Keep cool and keep the questions coming to

optionsforum@thestreet.com.

Behind the VIX

I have become somewhat confused with the VIX and how it relates to the overall stock market. There seems to be a correlation between low volatility and an increase in the market and high volatility and a drop in the market. Is that correct and why is that so? -- Ron Dunn

Correct, dear reader, there is a correlation. And you walked

purrr-fectly

into our trap -- a.k.a. Frequently Asked Questions! Soon, we'll refer general questions about options, such as those about the VIX, to an FAQ section. We will keep you posted on our progress in that direction.

Meanwhile, back to the correlation between volatility and the stock market. We consulted Murali Ramaswami,

Lehman Brothers'

global head of equity derivatives research, for an expert-to-lay-person (that would be me) translation.

To start, volatility is a measure of the amount by which an underlying security is expected to fluctuate in a given period of time -- generally, it's the amount by which a stock bounces around each day, measured over a period of a year. Usually, it's a measure of uncertainty.

The broader stock market also has a volatility gauge, the

Chicago Board Options Exchange Volatility Index

, or VIX, the key formula on which options traders train their eyes as a sentiment reader.

Here's the math behind the VIX: The market volatility index computes the volatility of four

Standard & Poor's 100

index, or OEX, options contracts in two nearby months: one call and one put just out of the money; and one of each just in the money for each of the two front months.

The catch here is that volatility doesn't indicate direction -- only movement.

There are a few reasons why low volatility often coincides with a rise in the stock market and high volatility with a fall.

"The negative correlation between volatility and return has a few explanations: As equity prices go up, the market value of the publicly traded firm increases, and its so-called debt ratio (the amount of debt carried vs. the total market capitalization) actually decreases. So that means the company's economic fortunes become less volatile. As the stock price goes up, the debt ratio goes down. That's a simple economic explanation," says Ramaswami. In other words, volatility is roughly in line with the amount of leverage a company is carrying on its back.

Conversely, in a bear market, stock prices are falling, the ratio of debt-to-market-capitalization rises, and the company's fortunes inevitably turn more risky.

"The other explanation obviously is that as the market rises, price deviations don't remain constant. In fact, they will probably start to level off, and that shows up as lower volatility," he explains. For example, let's say a stock trading at 100 rises to 150, then to 170, and to 180. Result? The average long-term price change becomes more constant over time. As a ratio of the stock price, the change becomes smaller."

Back to Basics

I am looking to learn more about how trading is done in index options and futures trading (from the basics to more complex notions) because I have seen that their behavior differs from that of stock options and that the volatility seems to give big opportunities for trading. Is there any book, site or reference that comes to mind that I should see? -- Federico Schiffrin

We consulted hedge fund manager Ron George of

Sorrentino Asset Management

, who worked for many years as a trader in Standard & Poor's index options and futures on the Chicago floor.

Right away, he advised all options newbies to point and click to

OptionSource.com, put together by "one of the better traders out there, Bernie Schaeffer, and through this program you could be trained the same way as a floor trader."

"It's not cheap, but it's valuable," says George. "You get what you pay for." Schaeffer is chairman of

Schaeffer's Investment Research

and author of

The Option Advisor: Wealth-Building Strategies for Equity and Index Options

.

Schaeffer this month also put out an interactive home study course in basic and advanced options-trading techniques for all levels of investors.

What other Web sites does George like? "The best options trader I ever knew was John Stafford, of

Stafford Trading

in Chicago. Anyone who's been down to the CBOE trading knows him. Now he's got a Web site and training program called the Edge System," reachable at

www.edgesystem.com.

Lastly, says George, there is Jon "Dr. J" Najarian's Web site,

1010WallStreet.com.

As for books, "well, the bible is McMillan," says the former floor trader. He's referring to

Options as a Strategic Investment

by Lawrence McMillan, an oft-quoted options guru and head of

McMillan Analysis

. "Start out with him and go from there to Sheldon Natenberg's

Options Volatility & Pricing

."

As for futures trading, "I haven't seen anything that isn't really squirrelly. But you won't learn trading futures by reading a book. Understand the underlying stock, and that will help first."

Other advice? "Brush up on Elliott wave theory and other technical analysis that would apply to the stock market, because if you have the direction right, you can make up 90% of your mistakes in futures. Price action is much faster and more volatile, in the futures market especially. Long term to me is 20 minutes. A lot of my trades are less than five minutes." Whew!

Remember,

TheStreet.com

does not -- repeat NOT -- vouch for one Web site or trading trainee program over another. And as with all investing,

caveat emptor

.

TSC Options Forum aims to provide general securities information. Under no circumstances does the information in this column represent a recommendation to buy or sell securities.

TheStreet.com has a revenue-sharing relationship with Amazon.com under which it receives a portion of the revenue from Amazon purchases by customers directed there from TheStreet.com.