What Does Volatility Mean When Trading Options?

Want to know how to take volatility into account while trading options?  Or would you like to know how to (or how not to) trade volatility?  If so check out the following article from Equities.com.  It does a good job of delving into the subject of  volatility.  Leave a comment and let me know your take.

Last week was a tough one for bulls as the market took a pretty sizable tumble. As a result, looked to the Chicago Board Options Exchange Market Volatility Index (VIX), which is popularly known on Wall Street as the market’s fear index. When stocks, specifically the S&P 500, begin to fall, traders will often look to the VIX as a way to get a handle on the market’s sentiment going forward. The index tracks options activity to project estimated volatility in the coming 30-day period.

With the VIX heading back up and gaining renewed attention from traders, we asked Toni Turner of TrendStar Trading Group in this week’s discussion for her thoughts on what the index rising could mean for the market.

EQ: The market fell quite hard last week, and the volatility index spiked back to near its year-to-date highs. Given that the VIX usually has an inverse relationship to the S&P 500, does this suggest that the market could be ready to move lower at a faster rate?

Turner: As a matter of fact, it Thursday’s close of 24.49 was above its January high. It was the most volatile candle I’ve seen on the VIX for quite some time now. So it does appear that we are now moving at a much faster pace, and fear is definitely coming into the market as the situation in Europe is deteriorating rapidly. However, the VIX is now rising into resistance just up ahead at about 25. It does have the 200-day moving average and the December lows to deal with, but if something truly dramatic happens in Europe and the situation continues to meltdown, then I suspect the VIX will move higher.

EQ: The VIX is widely known as the “fear gauge” for the market. How can traders use this index to get a pulse on the investor sentiment?

Turner: The VIX is the CBOE’s fear indicator. It is an options formula. When it moves higher, it shows that more traders and investors are hedging their positions by buying puts. The more frightened market participants are, the more puts they buy, and as a result, the higher the VIX rises. It is tied to the S&P 500, and I believe it is about 80 percent correlated. There are some days, though, where you’ll see the S&P 500 is falling yet the VIX is just staying in a small range and not rising. This usually indicates to us that even though the broader market is falling, fear is not coming into the market at a rapid pace. That is one way we may use it as an indicator that things aren’t as bad as they look despite the index falling. Conversely, sometimes the market is just moving along sideways and looks like it’s doing fine, but the VIX starts rising. That tells us, for whatever reason, fear is coming into the market and traders and investors should pay attention.

EQ: There are ETFs for the multiple volatility indices tied to the S&P 500, DJIA and Nasdaq. Do you ever consider these as vehicles for trade setups? Do you trade them differently than other stocks or ETFs?

Turner: I do occasionally play the Barclays iPath S&P 500 VIX Short-Term Futures (VXX). With that said, I would almost rather sell short a sector via an ETF than get into trading volatility indices too often. I know they can be helpful and I do trade them occasionally, but not habitually, because there are other places I’m happier to trade.

EQ: For traders with a higher appetite for risk, one way to play higher volatility would be using leveraged inverse ETFs. What are your thoughts on these vehicles?

Turner: Leveraged inverse ETFs move at a higher percentage rate and in the opposite direction of their underlying index, and they are available for many sectors. For example, ProShares has a lot of those types of funds out, and there are other companies that offer them as well. But leveraged inverse ETFs perform best if you’re trading them for one or two days, and you shouldn’t hold them for more than three days, or so. They do not perform well if you intend to hold them for the longer term because they’re not constructed to do so. What worries me is that many new traders will get into these leveraged inverse ETFs, miss their stops and then hold them in hopes their losing trade will morph into a winner. Leveraged inverse ETFs are great tools as long as you trade them in the way that the issuing company intended for them to be used. When the market is falling, many times I will short the leveraged (not inverse) ETFs. Because of the compounding effect inherent to these funds, as long as you are on the right side of these trades, they can yield great profits.

As far as leveraged inverse ETFs, I do occasionally trade the Direxion Daily Small Cap Bear 3X Shares (TZA), and last week, it moved up nicely. Also, the Advisor Shares Active Bear ETF (HDGE) is one that I’ve just started to watch and it looks like it might be a promising hedging tool. .

EQ: Are there any particular sectors or groups that you’re watching closely now?

Turner: As far as the overall market goes, I watched the S&P 500 move through 1306, and now the next move to watch would be 1300. Again, if the situation in the market deteriorates, we move lower here and get a flush down to perhaps even the 1258 level. What’s worrisome is that the banks and financial institutions have sold off here. You can watch the Financial Select Sector SPDR (XLF) and see that they’re selling off, certainly on the back of the JPMorgan (JPM) news, but perhaps even more so on the deteriorating problems in Europe. The XLF needs to hold its 200-day moving average.

Some other areas I’m watching are the June futures for crude oil, which is down to $92.55. It actually has support here from September. I’ll be interested to see if crude can slow its fall and hangout at around $92 for a little while, and possibly even getting a push up. Natural gas is holding up pretty well, and gold had an oversold bounce.

For a lot of people a lot of new traders to the market, I think the sidelines are a great place to watch until we confirm where a tradable bottom of this move is. There’s a lot of fear in this market and I will be very careful with my stops and share size on the long side. We are just moving into the summer months, and if the current volatility continues, I suspect the market will lead us on a merry chase.

Go to Equities.com for the rest of the story

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