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

In 1993, the Chicago Board Options Exchange launched the market volatility index, aka VIX. This index tracks the implied volatility of options on the US stock market index. It is commonly referred to as the ‘fear 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 implied volatility in options? A basic feature of option prices is this: when the volatility of the underlying asset goes up, the option prices go up. That’s true for 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 either 90 or 110 with equal probability. What is the value of a one-month call option on the stock with a strike of 100? Well, the call is worth 0 if the stock falls to 90 and is worth 10 if the stock rises to 110. Thus, the call is worth 0 or 10 with equal probability, so its fair value today is 5.

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

Also read: How you can avoid the fate of most retail option traders

Here we can see how an increase in the stock’s volatility caused the fair value of the option to increase, without any change in the current stock price. Higher volatility increased the upside payoff (from 10 to 20), but did not affect the downside payoff (stays at 0). Thus, the fair value today is higher. You can replace the previous example with a put, and the same logic will hold. Thus, for both calls and puts, higher volatility of the stock increases the value of the option.

Calculating implied volatility

In practice, we don’t know the volatility of the stock. We can try to make a good guess, but it is inherently uncertain. What we can observe is the option price. Implied volatility is when we use option price to work out the stock’s future volatility. In the example above, if we observe the call is worth 5, we conclude that the stock could go up or down by 10. If we observe the call is worth 10, we conclude that the stock could go up or down by 20.

This is what VIX does. It uses the option price to work out 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 an annualised expected volatility over the next month. A VIX of 20 means an expected volatility of 20% a year over the next month.

Also read: How to execute an option spread strategy

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

Normalised prices exist in other asset classes, too – the yield on a bond or the P/E ratio of a stock, for example. A bond yield or a P/E ratio makes it easy to compare prices and expected returns of different bonds or stocks. The VIX index does the same thing for options.

How to use VIX to trade options

Now let’s talk about how we can use VIX when we trade 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 some recent historical period, say three years. Since 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.

Given this data, we can conclude the following: when VIX is below 12.6, options are relatively cheap. When it’s above 18.2, options are relatively expensive. When options are cheap, it’s time to buy them. When options are expensive, it’s time to sell. Going back to our fear and greed analogy, when options are expensive (high VIX), it means the market is fearful. We take advantage of this by selling options. When options are cheap (low VIX), it means the market is greedy. We take advantage of this by buying options.

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

Beware: Selling options is far more risky

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

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

Also read: Five companies showering shareholders with buybacks and bonus issues

It is important to use your judgement and intuition, too. For example, a stock with a low P/E ratio is often a signal of a good opportunity. But sometimes it’s a sign that the company is in trouble. Similarly, a high VIX is often a good opportunity to sell options. But other times, the fear may be justified and it’s better to wait. Either way, keep an eye on VIX. See what moves it day to day. As you get a feel for it, you’ll be better placed to use it to time your option trades.

Note: The purpose of this article is to share interesting charts, data points and thought-provoking options. It is NOT a recommendation. If you wish to consider an investment, you are strongly encouraged to consult your advisor. This article is for strictly educational purposes only.

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

Disclosure: The writer or his dependants do not hold any of the assets discussed in this article.