Interested in options? Here’s how to use VIX to time your trades.

In 1993, the Chicago Board Options Exchange launched the market volatility index, also known as VIX. This index tracks the implied volatility of options on the US stock market index. It is commonly referred to as the ‘anxiety index’. Following its success, the National Stock Exchange launched the India VIX in 2008. This tracks the implied volatility of options on the Nifty stock market index.

How volatility affects option prices

What exactly does this VIX tell us? What is the implied volatility of options? A basic characteristic of option prices is this: when the volatility of the underlying asset increases, option prices go up. This applies to both calls and puts. Here’s a simple example that explains why.

Imagine a stock is worth 100 today. Next month it will be worth 90 or 110 with equal probability. What is the value of a one-month call option on the stock with a strike price of 100? Well, the call is worth 0 if the stock falls to 90 and is worth 10 if the stock rises to 110. So the call is worth 0 or 10 with equal probability, so its fair value today is 5.

Now suppose the stock is more volatile. Today it is still worth 100, but next month it will with equal probability be worth 80 or 120. The call is now worth 0 if the stock falls to 80 and worth 20 if the stock rises to 120. So the call is worth 0 or 20 with equal probability, and its fair value today is 10.

Also read: How to avoid the fate of most retail options traders

Here we can see how an increase in the stock’s volatility caused the option’s fair value to increase, without any change in the current stock price. The higher volatility increased the upside payoff (from 10 to 20), but did not affect the downside payoff (remains at 0). The fair value is therefore higher today. You can replace the previous example with a put, and the same logic still applies. So for both call and put options, higher stock volatility increases the value of the option.

Calculation of implied volatility

In practice, we do not know the volatility of the share. We can try to make a good estimate, but it is inherently uncertain. What we can observe is the option price. Implied volatility is when we use the option price to calculate the future volatility of the stock. In the example above, if we see that the call is worth 5, we conclude that the price can rise or fall by 10. If we see that the call is worth 10, we conclude that the price can rise or fall by 20.

This is what VIX does. It uses the option price to calculate the expected or implied volatility of the market index. The real world is more complex than this simple example, but the method is the same. The actual number is the expected annualized volatility for the coming month. A VIX of 20 means expected volatility of 20% per year over the next month.

Also read: How to execute an option diversification strategy

Back to what VIX tells us. Because implied volatility and option prices move in the same direction, VIX is essentially a normalized option price. ‘Normalized’ means it is comparable across assets and over time. For example, the India VIX is currently 15.9. The CBOE VIX is currently 21.5. Options on the S&P 500 index currently cost more than options on the Nifty index. (This is probably due to the upcoming US elections). A year ago, the India VIX was 12.1. So useful options are more expensive today than a year ago.

Normalized prices also exist in other asset classes – for example, the yield on a bond or the price/earnings ratio of a stock. A bond yield or a price-to-earnings ratio makes it easy to compare prices and expected returns of different bonds or stocks. The VIX index does the same for options.

How to use VIX to trade options

Now let’s talk about how to use VIX when trading options. The goal is to determine whether options are currently cheap or expensive. A simple way to do this is to look at the range of the VIX over a recent historical period, such as three years. As of November 2021, the average of the India VIX index is 15.6 – 25% of the time it is below 12.6, 25% of the time it is above 18.2 and 50% of the time it is between 12.6 and 18.2.

Based on this data, we can conclude the following: when the VIX is lower than 12.6, options are relatively cheap. When it is above 18.2, options are relatively expensive. If options are cheap, it’s time to buy them. When options are expensive, it’s time to sell. Returning to our analogy with fear and greed, when options are expensive (high VIX), it means the market is fearful. We benefit from this by selling options. When options are cheap (low VIX), it means the market is greedy. We benefit from this by buying options.

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Whatever your view on the market (bullish or bearish), you can express it by buying or selling options. If you are bullish, you can buy a call or sell a put. If you are bearish, you can sell a call or buy a put. You can use the VIX index to determine whether to buy or sell options. Option spreads can also be used to limit risk.

Please note: selling options is much riskier

Now there is an important caveat here. Selling options is risky – much riskier than buying them. I recommend that you don’t sell options unless you have some experience and enough capital to handle large, occasional losses. How to sell options effectively while managing the risks is a topic for another time.

If you’re not ready to sell options yet, you can still use the VIX to your advantage. You can buy options when the VIX is low, and you can’t trade them when the VIX is high.

Also read: Five companies that shower shareholders with buybacks and bonus issues

It is important to use your judgment and intuition as well. For example, a stock with a low price-earnings ratio is often a signal of good opportunities. But sometimes it’s a sign that the company is in trouble. Likewise, a high VIX is often a good opportunity to sell options. But other times the fear may be justified and it is better to wait. Anyway, keep an eye on VIX. See what moves it from day to day. As you get a better feel for it, you’ll be able to use it better to time your options trades.

Note: The purpose of this article is to share interesting graphs, data points, and thought-provoking options. It is NOT a recommendation. If you would like to consider an investment, we strongly recommend that you consult your advisor. This article is for strictly educational purposes only.

Asad Dossani is an assistant professor of finance at Colorado State University and has a PhD in economics. His research includes derivatives, forecasting, monetary policy, currencies and commodities. He previously worked as a research analyst at Equitymaster and as a financial analyst at Deutsche Bank.

Disclosure: The writer or members of his family do not own any of the assets discussed in this article.