What do we do when it turns around?: A great question that is on the minds of many traders these days. But I’ve got a better one: When what turns around? Many traders focus (maybe too much) on the obvious. Yes; the “market” (i.e. the S&P 500 index) is down at a relative extreme low. This, arguably, presents an opportunity for long-term investors who believe that one day, the market/economy will turn around and erase its recent problems. But there is another index that is sitting at a relative extreme as well: the VIX.
The VIX is the CBOE’s volatility index which (in a round about sort of way) measures the market’s expectations for future volatility in the S&P 500. Specifically, the VIX measures the 30-day implied volatility of the SPX (the tradable option index on the S&P 500). The VIX has been over 50 lately, which is a very high level at which to be spending so much time. In years past, a more typical level for this index was in the low 20s.
Implied volatility buffs often refer to “reversion to the mean”. This is the situation in which implied volatility makes a move away from its typical range and then reverts back to its “normal” level. Looking at the VIX now, it’s hard not the think, “what goes up, must come down”. To profit from falling implied volatility, one must sell options.
But it’s a little bit tricky, this volatility game is. First, We don’t know when implied volatility will decline. To be sure, it could be months. With the wily market we’ve seen lately, most traders don’t want to be short options for an extended period of time.
Second, probably, after it’s all over, the VIX will not return to the levels seen earlier in 2007 and 2008. It will likely remain a bit higher for a while as the sting felt by traders remains at the back of their minds.
Bottom line: the VIX will likely fall (one day) but it’s not likely to collapse. To take advantage of this decline, traders need to be proactive, but careful. Cautious traders will watch volatility closely and wait until just before it looks like it is starting to wane to sell. And then, traders must monitor positions closely looking to exit if their wrong. Capturing a downward move on implied volatility can be profitable, but the risk of being short (naked or covered) can outweigh the potential gains.
Face it. If trading was easy, everybody’d do it! To succeed, one must look for opportunities, where others don’t. Implied volatility is something that common traders often overlook. But this trader says it’s worth keeping an eye on.