VIX is the CBOE volatility index and is constructed to provide a good measure of the implied volatility for SPX (S & P 500 Index) options. In general, VIX is an excellent proxy for implied volatility everywhere because when VIX rises or falls, the implied volatility for the vast majority of equity and index options rises and falls along with it.
VIX established another intraday record high (81.17)* Wednesday. Here's a graph of VIX values for the past few years. For detail oriented readers, VIX was significantly higher (almost double today's record) during the crash of October 1987, but there are two important items (plus other differences) that should be mentioned.
*Visit; Change date to 10/16/2008
1) VIX data officially goes back to Jun 1, 1988, but the index value can be calculated for earlier dates.
2) In those days (prior to 2003), VIX was calculated using OEX (S&P 100 Index) options. That data is still available (symbol VXO). Today, SPX (S&P 500 Index) options are used to measure VIX.
In today's very volatile markets, there are many more option buyers than sellers. That extra demand, coupled with the risk involved when selling options, results in higher option prices. Higher option prices means that the option's implied volatility is higher – as seen by looking at the recent spike in VIX graph.
Some traders buy options to speculate on a continuation of a very volatile market. Others buy put options to protect the value of a portfolio. Large hedge funds may be buying or selling as needed to manage their portfolios. One thing is certain – option trading volume is high.
One reason for high prices is that option sellers understand the risks they are taking and demand higher and higher prices before being willing to sell. Thus, VIX increases.
What's an Option Trader supposed to do?
It's reasonable to go with either of these ideas:
- VIX is so high, traders can easily profit by selling vega
- The market is experiencing extreme volatility. Thus, it's best to sit on the sidelines
Most of the basic strategies that I recommend involve positions that are short volatility (as measured by vega – the rate at which the value of an option changes when it's implied volatility changes by one point). In other words, these strategies perform well when VIX decreases (after the position is initiated) and lose money when VIX increases. The strategy I discuss most often (at least so far) in this blog, iron condors, is such a strategy.
Thus, the question that should be on the mind of option traders: should you, the buyer of iron condors (or any other strategy that has negative vega), be venturing outdoors, or hiding under the bed? [Reminder: Buying an iron condor means selling one call spread and one put spread in same underlying instrument.]
There are risk-reducing methods you can adopt to protect yourself against large losses, but that protection is not cheap. The basic idea is to buy a small quantity of extra calls and puts. This cuts profit potential, but all insurance is costly.
What to do? The answer depends on your individual comfort zone and tolerance for risk. The best compromise is to do both; i.e., continue to buy iron condors, but buy fewer.
Speaking for my comfort zone, and trusting that you will make an appropriate decision regarding yours, it's a good idea to buy iron condors, sell credit spreads, or even write covered calls and sell cash-secured naked puts. But, please be certain you understand the risk of each strategy, and don't accumulate more positions than your comfort zone, and pocketbook, can handle.
These option prices are high for a very good reason. Thus, selling options and collecting fat option premium may be very attractive or very frightening, depending on your outlook. But, there is no easy money to be made here. Risk management is more essential than ever.