If you’ve watched the craziness of the market the past few weeks, you’ve heard a lot of talk about the VIX index. I want to explain exactly what the VIX is and how it affects your portfolio.
To understand what the VIX is, we first must have a primer on options. An option is a simply a financial contract. Every option has a buyer and a seller. There are two types of options, calls and puts. The buyer of a call option has the right to buy a particular security at a specific price for a defined amount of time. The buyer of a put option has the right to sell a particular security at a specific price for a defined amount of time. The seller of a call option is obligated to deliver the security at the specified price if the buyer chooses to exercise, while the seller of a put option is obligated to buy the security at the specified price if the buyer chooses to exercise.
The big picture is that a knowledgeable investor can use options to hedge risk in their portfolio. If an investor is worried about a large market decline over the next 3 months, he/she could buy 3 month put options to hedge the downside risk. If the decline never happens, then the investor is out the premium paid for protection. If this sounds familiar, it should. It is just like any other insurance – home, car, etc. You get the picture.
The question is, how much should an investor pay for this insurance. Aha, this is where it gets very interesting. Options are traded just like any other security, on an exchange in a free market. There is supply and demand, and this determines the price. All investors use a formula to determine the correct price of an option. One of the inputs to that formula is an estimate of the volatility, or movement, of the security price over a specified time period. If investors think that a security will be fairly steady over the next month, then the volatility estimate will be low. If investors think that the price of a security will vary widely, then the volatility estimate will be high. This estimation of future price movement is a huge component of how expensive option prices will be. Think about it, if you are the insurer, or seller of the options, wouldn’t you demand a much greater premium if the likelihood of your paying off was high? This is how the insurance industry works. Upon news of an approaching hurricane, insurance premiums skyrocket.
The VIX is the ticker symbol for the Chicago Board Option Exchange Volatility Index. It is a measure of the implied volatility of the near term options on the S&P 500 index. The VIX is quoted in terms of percentage points and translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period, on an annualized basis. For example, if the VIX is at 15, this represents an expected annualized change of 15% over the next 30 days. After some straightforward math, one can infer that the index option markets expect the S&P 500 to move up or down 1.17% over the next 30-day period. That is, index options are priced with the assumption of a 68% likelihood (one standard deviation) that the magnitude of the S&P 500’s 30-day return will be less than 1.17% (up or down).
When tracking the VIX index over time, it is easy to see that the VIX tends to move opposite to the movement of the market. When the market is moving higher, the VIX usually falls. When the VIX reaches a very low point and the market reaches a top, the cost of portfolio protection in the options market is very low. When the market starts to turn over and head south, the VIX index can move up very rapidly.
Over the past several months, option premiums have been very low. The VIX has been in the mid teens. Today (May 7th) the VIX hit 40. What does this mean for the average investor? It means that if you’re thinking of buying puts to insure your portfolio it’s probably too late. The cost is now very high. On the other hand, if you understand options, it is a great time now to be an option seller. Option sellers have a huge advantage in a high volatility environment, as long as they understand how to manage risk.
We sell call options every month against our portfolios to generate income. When the markets decline rapidly as they have this week, these option premiums get very expensive, allowing us to generate very nice income in a declining market. If you are interested in learning more about our managed portfolios which all contain very conservative option selling strategies, please give us a call.
