By Chris Ebert
Stocks and Options at a Glance
*All strategies involve at-the-money options opened 4 months (112 days) prior to this week’s expiration using an ETF that closely tracks the performance of the S&P 500, such as the SPDR S&P 500 ETF Trust (NYSEARCA:SPY)
This Week’s Options Insight
Every day, option traders all over the world haggle over what each trader believes is a fair premium based upon their individual prediction of future stock prices. The haggling has gone on ever since the invention of options, but it wasn’t until fairly recently, somewhere around 1993, that someone had the idea to reverse engineer the process and interpret the results.
If predictions about future stock prices determine option premiums, then an analysis of option premiums should reveal traders predictions. When an analysis of options was performed on the stocks in the S&P 500, the result was a prediction that is now known as the VIX (CBOE Market Volatility Index).
Since 1993 the popularity of the VIX has grown. For those traders not yet acquainted with the VIX, it is simply a statement of the expected range of the S&P 500. For example, a VIX of 20 indicates a prediction that the level of the S&P will be within a range of 20% higher to 20% lower than it is today, exactly one year from now.
Volatility can be a somewhat complex subject, but there is a simple formula that can be useful for most traders: Volatility is generally about half as much when the period of time is reduced to one quarter of the original. For example, if the S&P is expected to be within a range of plus or minus 20% a year from now, then it would be expected to be within a range of plus or minus 10% a quarter of a year, or three months, from now. Continuing the process, the expected range would be plus or minus 5% three weeks from now, and plus or minus 2.5% five days from now.
The VIX is widely publicized, especially when it changes significantly. But, reports of the accuracy of the predictions implied by the VIX are much less common. For example, if the VIX was 20 three months ago, that would imply a trading range today of the S&P of +/-10% from the S&P’s level at that time. If in fact the S&P was trading 15% above the level of three months ago, that would indicate an inaccurate prediction by the VIX, but such an inaccuracy would likely go unnoticed. It is the prediction that tends to interest folks, not the outcome.
To be fair, the VIX does not make a blanket prediction, but rather places conditions on the forecast, not unlike a weather forecast. As an example, a VIX of 20 would imply a 70% chance that the S&P would be within 10% up or down, three months in the future. So, technically the VIX is not flawed if the S&P ends the period with a gain of 15%. But it surely doesn’t paint a picture of the VIX having a good handle on the future.
When the VIX fails, or stated more accurately, when the S&P experiences low-probability outcomes as predicted by the VIX, that should be a heads up for traders. After all, Continue reading “Is The VIX A Hypocrite?” »