Listen to the Podcast
Hey, this is Sasha Evdakov and welcome to episode number 89 of let’s talk stocks. Today we’re going to talk about the VIX, and more importantly, how you can use the VIX for trading stocks, but also options.
The VIX typically refers to option trading, and it’s geared and run by the options. But I’m going to share some insight with you about how to use it as a gauge for also if you’re trading stocks in general.
Before we get there, I want to say thank you for everyone who downloaded the book “20 rules for investing success”. You can go ahead and take a look at that book on tradersfly.com, and there’s a “get it now” button.
Especially thank you to those of you that did the customers review for that book. I know it takes a little bit of time and effort to do the reviews. Thank you, and I’m sure a lot of other people will also appreciate that as well, as they read through the reviews to see the insight that you’ve gained from the book.
I did make this book as cheap as I could. Kindle will only allow you to go down to 99 cents, so that’s what I made it. And for the paperback they let me go down to $5.38, so that’s what I made is, that was the printing cost. I made it as cheap as possible, so those of you that still want the book, you can go ahead and get it here on Amazon. For those of you that have kindle unlimited of course, it is free because you’re paying for that membership.
One of the other things I did today was work a lot on the options course and just trying to get more and more material filmed. We’re up to about 50 hours on that course, give or take about 5 to 7 hours.
That course is starting to add up in time and lessons. It’s going to be a multi-course. So there’s going to be multiple segments to that course, and we’ll probably have it released by about August time. By the time we finish the editing, study guide, sales pages, and the manufacturing, it’s going to take a little while. We still have to wrap up one of the diagonal sections here, which is one of the things that I’ll be using here in the example to go through this lesson on the VIX. That’s what we’re going to go over today and let’s get into the teaching.
Here you can see, I have a sample account, you can see Apple, Google, Netflix, SPX, these are just some baseline positions in a simulated fake paper money account.
What is the VIX and how does it work?
When you’re trading options, the VIX is usually the tool or utility that drives these option prices, but it can also be used to trade stocks. If you don’t trade options, stay with me here, and I’m going to share with you some insight as well about how you can use it for stocks.
First off, before getting into the VIX and how you can use it, let’s talk about how it functions or behaves, or what does it tell you?
It’s a fear indicator. If you haven’t heard that before, it’s the number of puts that are basically purchased on the S&P 500. The thing is, if I take the S&P 500 over here, you can see the S&P, as it moves higher to the upside, people are less scared. They don’t feel like they need puts, and puts are insurance on your stock.
For those of you that have health insurance or have car insurance or any insurance, even if you’re the same age as another person, if you have preexisting conditions, your health insurance premiums might be much more. That is because you are riskier.
If you’re smoking, if you’ve been smoking, if you’ve had health problems, heart conditions, surgery, those kinds of things, your insurance premiums are going to skyrocket even if you’re the same age as another person.
Fear is stronger than greed
This is the fact that the VIX tells you; it’s the risk factor of the market. The risk factor is determined based on the volatility, and how a stock can snap. It can snap to the upside or the downside. But typically, as we know and understand, stocks typically snap down, they don’t usually crash to the upside, they typically crash down if they crash. They usually don’t crash to the upside, and that is just because fear is stronger than greed.
It’s just a natural cause of energy. It’s natural; gravity will pull things towards the center of the earth. In the same way, if you’re pushing against gravity to support a stock for it to continue to go higher, you have to push it higher. How do you drive it higher? By buying that stock.
You’re pushing it with your money, and you need more and more money all the time to keep pushing it higher, that’s a lot of energy. It’s all a game of power.
As stocks continue to go higher, and you can look here in this diagram, with the VIX CBOE volatility index that I put here at the bottom to TC 2000. You can go ahead and have that by clicking the little plus at the top, and then you can type the VIX, and then you go to the market volatility index.
When you have that up, you can see that any time you have a little sell-off, the VIX spikes up, and once it spikes, you can see that we get a little high and low range. It’s like looking at the McClellan Oscillator, and you can see that you have a scale at the high end, overbought and oversold range. What you're doing is you’re drawing the upper band and the lower band of that. And then it gives you an idea of overbought or oversold, just like the RSI indicators.
Merely looking at the VIX will tell me how volatile. If you go to the VIX, and then right here CBOE, it gives you an idea of some of the high and low ranges. And I can go ahead and delete some of these drawings. If you back up and backtrack in history, you will see that kind of the lows are right around that $12 range.
The ultimate high is in that 2009 level, which you can see was hitting those highs in the $90 range, but overall, the average highs are in the $30 range, or 30 point range. Those are the higher upper band levels.
The VIX vs. The market
And more recently, if you want to get a little tighter, you can say it’s about level 20. Which right now at the current level, we’re hitting kind of that $20 level, and now we’re pulling back a little bit. So you see we had a little pop in the VIX.
What does this tell me? Any time the market, if you go to the S&P, the market tends to sell off, the VIX tends to spike. If you go back and you take a look at this on the monthly chart over here, you can see that when we had these pullbacks in 2000, 2001, 2002, 2003, we had higher VIX to spiking.
When we had the upward motion in 2004, 2005, 2006, 2007, the VIX went down we were right around the 15 points on the VIX. As we went into 2008, 2009, the VIX spiked up again, and then we had about an 80-90 point on the VIX, a lot of fear during that time frame. Now, since 2009 we’ve been going to the upside, and that’s when you can see the VIX was slowly starting to come down.
But with every pullback, people were nervous because of that 2000 and 2008 year of that pull back. People were worried that it would repeat and continue moving to the downside. And that’s why you see the VIX spike a little higher as we get these pullbacks, just as we had in 2011, 2012.
And now if you look a little more in an intraday or more on the daily charts, you can see that anytime we get major sell-offs, the VIX will pop, which dictates the price of the puts and the calls.
If we go into our trade pricing, you can see the price here between the bid and the ask, the costs of these will shoot up as that VIX pops higher. The higher the VIX, the more expensive this bid and ask price. If you get higher prices, that is going to allow you to do much more in trading.
Beginners hate a high VIX
Beginner investors hate a high VIX because things are more expensive. It’s more costly to buy put or calls, and the market whips around.
For example, if you look at today’s action, we look at the intraday. You can see we had a significant sell-off, we had a sell off pretty good, it was about 14-15-20 point sell-off. What happens then is that we popped back higher in positive territory, and that’s what you’ll get in these volatile market environments.
Professionals love a high VIX
When the VIX is high, you get whipsaw action, ad many beginners don’t like this because the market is not calmed. It feels like it’s behaving irrationally, but the professionals love this, why is that? Because now you get movement in the stocks.
You could be buying stocks at the lower prices. Then they whip back up, and you can get out of those positions, and you make money for the day, as much as you would maybe in two or three weeks as the market was heading higher. That’s one of the reasons why these professionals love volatility.
The market will typically crash down rather than up
When you look at this, one of the reasons this happens is again, because the market usually crashes down rather than crashing up. So backing up again on our monthly chart, how long did it take from 2002 to 2008 to go up? It took about 5.3 years. However, when we went down, how long did it take to go down? About 1.5 years.
The market when it goes up, it takes a lot more energy to go up than it does to go down, so as I emphasized earlier, the market will typically crash down, not crash up. It takes a lot more energy to push a market higher. You have to keep putting money into the stock to keep it holding up and keep pushing it higher and higher.
Whereas for selling, you’re just selling the trigger of what you already have. That means that typically markets will crash down, rather than crash up. And when they crash down, the insurance premium of that becomes more expensive. That is the case because there’s more risk. Think of this like when you go to your insurance company to get health insurance. If you tell them that you’re a smoker, you’ve had heart problems that won't end up well. Imagine if you say them you’ve had diseases and you were exposed to biochemical. There’s a lot of issues that you have on your health. And in that case, your insurance premium is going to go higher. This is what happens here on these option prices and contracts, whether you do it on the put side or even if you do it on the call side.
No matter where you look, put or call, the insurance prices and the premiums on these puts and calls become more expensive. All of this is a good thing if you’re a seller of options, not a good idea if you’re a buyer of options. Most professionals they’re usually selling option premiums.
How to use the VIX for trading stocks
For us, when we’re trading stocks, this also tells us the volatility. The higher the VIX, right now, we’re at 19.37, the higher the VIX, the more whipsaw action we get.
For you, even if you’re not a trader of options, a higher VIX will tell you how much whipsaw action you’re going to get.
This is good to use when you’re setting stops. If you’re looking to trade a stock, you want to give it a little more room if you have a higher VIX, and that is because you’ll get more whipsaw action within those stocks. It doesn’t matter that the VIX is based on the S&P 500 because it’s going to affect other stocks as well.
If you’re trading like an apple right here, and you see that the VIX is higher, you might want to give yourself a little more cushion to the downside or the upside on your stops.
If you are trading like apple, Netflix, a Lowe’s, anything like that, and giving yourself 25 cents or 50 cents or $1 on the downside for that stock to break, then when you have a higher VIX, you might want to give yourself a little more room. You might want to provide it with $2 or $3, and that is because you’ll get that extra whipsaw action and the manipulation.
The VIX is related to volatility - Not direction
Remember, the VIX is related to volatility, not direction. Volatility is the spread, the price spread between the open and the close, so the more significant the price spread, the more volatile things get. The more whipping around you get, the higher the VIX.
And here, if we have a VIX and you go to this chart, the higher that VIX price, the more whipsaw action you’re going to get.
For you, if you’re trading stock, it doesn’t matter what it is, we’ll use Lowe’s right now as an example.
If you are looking to get into lows right here on this breakout, and you notice you have a low VIX, and you have a little bit of a tighter stop because the VIX is low. Just three days before that stock broke Lower, you can see that VIX is popping up to the 17 price range.
You could not have predicted this earlier, that you would’ve had the VIX popping in the future. All you can do is, if you’re in the position, you can reduce your risk, or number two, widen that stop.
I’m not saying that Lowe’s is going to continue moving higher. What I’m saying is that you’ll get this whipsaw action that draws down past these support levels, only to whip back up, because that VIX is higher. That’s what it does on the manipulation side.
If you look at Netflix here, you'll notice the same thing. We had this little whipsaw action, stock whips down, retest this support level, and then what it’ll do is take a look here on June 13th, 2016. It will whip to the upside only to come back later. And now it’s trying to rebuild that support and then it’s trying to pop to that upside again.
Widen the stop or reduce your position size
You’ll get some weird whipsaw action in the stocks as that VIX is high because a lot of it is emotional trading. You’ll get whipped around when that VIX is high because that fear is kicking in. So what do you do? Again, you can have a little bit of a larger stop on your stock if you’re trading stocks.
The other thing you could do is reduce your position size if you have a higher VIX and you’ve been long in positions. For example, if you’ve been trading (let’s say the Wynn) and you’ve been trading it to the upside since this break out in February and March, and you see a higher VIX, and the VIX is popping, you have information to make a decision. You could reduce your position just slightly when that VIX starts increasing. Meaning, take some of the profits off into strength, take your benefits and put them in your pocket. Then go ahead and allow the rest of that stock to run or come back to your stop.
That way, at least you’ve taken some profits off because it can whip around much more. And that way you see your earnings, it’s just going to fake you out, or psyche you out. That’s when a lot of people get nervous.
If you’re the type of person or trader that when you’re in a position, and you’re scared from the whipsaw action on the day to day activities, just like here we’ll take a look on these current positions, these sample trades that I have.
Maybe you’re worried about a position that’s down $30, or a position that’s down $100 here on Netflix. If you’re concerned about these kinds of actions, then you need to set a wider stop or trade lighter.
Or you need to trade in lighter volatility environments, but you can’t control those environments. You have to trade what’s out in front of you. So what you could do is reduce your position size and take profits into strength. Or lower your position size, or go ahead and widen your stop.
Sometimes it’s necessary to shift your stops
Those are some of the things that you could do. I don’t like to shift my stops, my stopping points personally. Because those are the key places that I’m watching. But in higher volatility environments, sometimes this is necessary.
Usually, if it’s a fearful problem, you probably need to reduce your position size, because you’re trading too large for your experience. But in general, volatility will get you those numbers to whip around even more. If you have less volatility, it’ll move very little on a day to day basis. In that case, you get greedier and say, “I wish my account would grow a lot faster.”
Trading options with the VIX
Those are some of the key points if you’re trading stocks regarding the VIX. Now, what about if you’re trading options or you’re looking to trade options? Well, here in this example, when we’re trading options, we want to be a net seller of options. And typically when you sell options, you want higher prices, just like when you sell anything. If I’m selling a pair of shoes, I want to sell them for as much as possible.
Here option prices are dictated in part by the volatility, so the more volatile things are, the more I can sell these option premiums for.
Let’s say I’m selling a vertical and I’ll go ahead and analyze this trade. If I’m selling this vertical, what I’m looking at is the current price. And the price that I’m selling this vertical at is telling me that I can sell this for $220 If I look at the lower left over here. And it shows me $220 is what I’m selling my vertical at. That is also the credit here, remembers one contract refers to 100 shares, so that’s $220 is why they come up with that number.
The green line here, if you’re looking at the video, the green line refers to the line at expiration. So right away we wouldn’t make $220. And the white line is the current today’s line, profit line.
As time moves forward, this white line slowly gets closer to the green line, due to the decay, the theta decay, and that’s what allows me to collect my premium, and at expiration, I would make my $220.
How does the VIX play a role in options?
How does the VIX play a role in this? Well, right now, with the VIX being right around 19-20 points, when it was at 22 earlier this week, I probably could’ve sold this same position, this vertical, for probably approximately $260. Maybe even higher. Perhaps around $270-$280 so I could’ve made $280 per contract, of course, if I made two contracts, it’d be $560, let’s stick to one deal to make it easier. With one contract, they could’ve made probably $280 if I sold it with a high VIX.
Now, as the VIX is slowly coming down, I’m only able to get about $220. If that VIX continues to move lower, then it drives the prices of options lower. Because the insurance, the risk is not there, so the insurance. Nobody wants to buy insurance, then how can I sell it? So I’m trying to get rid of it. If I can make it cheaper that allows me to get rid of it, so maybe I could get $180 on that insurance, which would be $1.80 times a hundred, $180.
That’s the thing, when you’re a net seller of option premium, like we are, selling option premium in the option business. By having a higher VIX, allows you to trade options for more money, and there for you to collect more premium on the options.
This is great, especially if you’re selling verticals like we just did, or if you do the S&P. You can also sell things like an iron condor, so if you go ahead and we analyze this trade, it’s basically two verticals on both sides. So what we can do is go all the way over here, and let’s say I move some of these strike prices, and now as you move these strike prices, you’ll get kind of an iron condor that will look maybe more like this. And now, you can make about $450 on that.
The higher the volatility, the more money you can make
If we had lower volatility, I would probably only be able to make $360 on it. I could compensate for that, and I could go a little wider on some of these, meaning drop down some of the legs. That’s the difference between these option contracts, and I could drop this other leg down, but still, I’m paying, and I’m getting less money in a lower volatility environment.
With higher volatility, these trades are fantastic to put on. Such as the iron condors, the butterflies, you also have the verticals, but when you look at calendars, calendars are not the best trades to put on in a high volatility environment.
If you look at a calendar, these are not the best trades to put on during a high volatility environment. That is because this trade is a positive volatility trade because you’re a net buyer of options. Even though you’re selling option premium because this is the business you’re in. Any business is selling things. That means that even if you’re trading stocks, you’re buying them, then you’re telling them, or you’re selling them and then buying them at a lower price if you’re going short. If you’re selling iron condors, you’re a net seller.
With a calendar, you’re still a seller, but overall, you’re technically a net buyer, and you can see this is a green bar before you saw them red. And that is because overall the amount of days that we’re buying is actually on a buy side. The way the calendars work is you’re selling the 28-day option contracts, and you’re buying the 63-day contracts, and how is option prices determined? Well, by the intrinsic and extrinsic value. That is the case when if they’re worth anything, that’s what that means, is if they’re in the money or out of the money.
If those are equal, if we’re trading the 2080 strike price, then that has no relevance. Then, if we go ahead and look at the volatility, the volatility is going to be 48 on the 28 days and then over here, we got about the 48 points as well. That's because volatility is the same today. I’m buying them all today, but the difference here is I’m spreading the time, the time difference, I’m selling 28 days, but I’m buying 63 days worth of premium. So because the difference here is I’m buying more time, I’m a net buyer of options.
This type of trade, you have to close it out, you can’t just let it expire. The reason is once you go through July and July expires, August starts kicking in, you are going to be losing money day in and day out, rather than when you’re doing an iron condor for example.
If I sell an iron condor or a vertical, any one of these trades, they all expire in one month, and you can see it’s red there. As I do an iron condor, we can spread these out, and when you spread them out, you get a little better view of what an iron condor will look like. And with these trades, you can allow them to expire completely.
You can allow them to sit and expire, but you’re just selling, you’reselling one in the same month, 2180, but you’re buying 2210. So if we look at this, and we go to let’s say 111 strike prices, so I’m selling the 2180 and buying 2210.
I’m selling the inner one right here, let’s say 2110 at $18, and then I’m buying back another one at let’s say $4 or $6. The difference between those is what I’m making. I’m selling one that’s more expensive, buying protection there.
Whereas with the calendar, it works a little bit different. So with the calendar, you’re buying more time, you’re selling. If we tighten this up, let’s say six strike prices, and you go, and you sell this one at $34, you’re buying the $50, so you’re buying something more expensive.
The reason this works out if you’re still wondering is that the one in July expires before the one in August. They’re at the same strike price because the volatility is currently the same as we put on the trade.
The difference is the days. That means that even though this one is more expensive in August, it’s $50. Whereas the one in July is $34. We sell $34 of premium, but we pay $50 of premium. Next, what we need to do is once this one gets to pretty much zero, or as close as we can get it, then we go ahead and close the other trade out.
This is what’s going on with some of these diagonals that I have. For example, if you take a look at Apple, I’ve done a diagonal on this one, they’re a little more rotated. But you can see that we have July and then August and we have a few contracts.
This is a bearish position, and as time decays, it goes closer and closer to that line. Now, when you put this on, it’s good to do these in a low VIX environment. Because this is a diagonal, its multi-month, and I put this on before the VIX popped. But if the VIX were high right now, I wouldn’t put this trade on. Instead, I would put more of the iron condor, more of a butterfly more of a vertical, those are the types of trades I would put on, on a higher VIX environment. And that is because the option prices skyrocket as that VIX pops.
Should you trade the VIX?
I hope this makes sense regarding the VIX, number one, it’s a fear dictator. Do I trade the VIX on its own? For example, you could trade the VIX on its own as contracts. No, I don’t. I don’t trade the VIX; I don’t use it as a hedge or anything like that. And that is just because I don’t trade fear. Why would you trade an emotion? It doesn’t make sense to me. There’s no point for that.
Instead, what I’ll do is I’ll look at the VIX, and I’ll look at the contracts, where are people buying the deals or selling the contracts? So here you can see the activity, where is that activity? And by looking at the VIX, it just gives you a gauge or an idea to how much whipsaw action you get in the market.
If you’re looking at the S&P, if you’re looking at it on a day to day basis, the higher the VIX, the more whipsaw action you’ll get. If the VIX is low, you typically will get little action to the upside, tiny movements, but you don’t usually get a lot of whipsaw action. That is the case just because there’s less fear in the market.
The VIX and the market are usually opposites
There’s a common phrase that some people think about when the VIX is low: look out below, because then the market is going to sell off, and that is because they work inverse. So when the market is high, the VIX is low.
When the market starts to sell off, and the VIX is high, the market is low. And they often work in the opposite. That doesn’t always work out, but it’s just a dictation of those put contracts. How much insurance people are buying to protect themselves?
And with Brexit being around the corner. All these uncertainties that they keep talking about with the fed, all this stuff, the presidential campaign, there’s a lot of doubts that happen.
When you look at the overall market, to me when I look at this market, I would think it’s quite extended, overextended. Can it still go higher? Yeah, we can. And we were pushing here on the air for multiple weeks. We were going higher and higher. It was brutal to my account for a little while, and then once we got this rollover effect happening, everything kicked in.
Going long vs. going short
Within just one day right here, look at that VIX popping, because we went from a VIX of about 14, and we popped to about a 17, within one day. That one day on June 10th, 2016, that one day took out. If you bring this day across, this is why I like shorting much more than going long, sometimes. Depending on the environment.
Often I like going long because you can make much more money going long to the upside. But when things are overinflated like this, overpriced, the reward is better to the downside. So I usually like to go long, in retrospect. I love going long more often, but when things are so inflated, I’d instead go short because you make money much quicker. You’re treading higher, but then in one day it wipes out, 13 days of gains you wiped out in one or two days.
Those are just some things to think about, is that you don’t have to be a bull or bear. It’s just about doing the trades appropriately for your account.
Generally, in that normal professional environment, you’ll make more money going to the upside. That is because stocks can go to the upside to the moon, to infinity. To the short side, they can do pullbacks and things like that, but they don’t usually go down to zero.
Most of the times, going long is the best or the better alternative. But when you do have those crashes that start coming in (especially if you start looking at this month), these days are painful for a lot of people, if you’re in the wrong side of the trade.
And sometimes once you start seeing this VIX pop, it’ll give you a little indicator of things could be happening. You can see here from 2007 to 2008 how the VIX started to pop a little bit at that 38 point level, and then we had a further major sell-off. And then the VIX shut up.
It’ll give you a little indication when that VIX is popping. Sometimes the money managers, they know better, they are protecting themselves against something. So watching it at those different levels will give you some gauge or insight of what protection is being purchased. And it gives you a little clue and idea of how much whipsaw action you’ll get.
If you’re trading stocks, reduce your position, you can go ahead and take profits into strength if you are profitable or you’re going to need to give a little more room for that whipsaw action.
Or if you can’t do it, get out of your position, you can put it on a little bit later. That is if you’re learning how to trade and you don’t want to be in those volatile environments.
If you’re trading options when the VIX is low, great to put on things like calendars, diagonals, those types of trades. Things that are more bullish, verticals because it’s cheaper on the premiums.
If you are in that seller, it’s better to do them when the VIX is high. When the VIX is high, you want to sell that premium, just like when the VIX is here at the 90, you want to be a seller, because people want them. If you’re giving the market what it wants, you’re able to capture on that. That's the kind of a contrarian thing to do, but this is the way the business works. If you’re giving people what they want, and if they want to buy put options, then if you’re a seller, it works out better in your favor.
I hope this gives you some insight into the fear indicator, the VIX. For me, it just comes down to looking at how much volatility is going to be in the market place. And the higher the VIX. We professional traders, we like higher VIXES because it whips the market around, and it allows you to sell a higher price premium. It also allows you to capture more significant runs, because the market will deep down, and then it’ll pop and spike up all in one day might get a 20-30 point move on the S&P.
It’s great for professionals, but beginners usually don’t like it. That is because they don’t understand the movements. It may seem erratic for them. But if you learn to embrace it, it’s going to be one of your favorite things when you start to see volatility.
Because you’ll be able to make a lot more cash on the downside in a shorter period, markets typically crash down or move down much faster than they move up. What's more, they can jump higher much more extended period, but as far as time goes, you can make much more money in a shorter period if you’re going to the downside.