Pay attention to index volatility

Now that Canadians are recovering from their Thanksgiving turkey dinners, it is time to pay attention to the marketplace once again.

One chart I will bring to your attention is the volatility index, VIX. It measures the implied volatility of the S&P 500 index. It is also equated with being the “fear index”. Implied volatility of the marketplace is highest during market crashes.

Historically, when the VIX goes under 18, it does not bode well for the marketplace – it’s a good rule of thumb (the lower the better) to watch out for complacency. Obviously since VIX is not a predictive index, you should not base your outlook on it, but it does convey the information that market participants are not betting on a crash (or a spike up) in the near term.

Traders that expect some form of volatility can bet on both sides of the marketplace – by purchasing a call and a put at a strike price, they will win if the market goes up or down a certain quantity. For example, right now with the S&P 500 at 1164, you can purchase a December expiry (December 17, 2010) call and a put, with a breakeven point of 7% movement (roughly 40 points in either direction). Conversely, you can profit if you sell the same options and the market does not move further than 7%.

Playing options are very difficult since you are fighting very good mathematical models, so I do not recommend them for casual investors. Most option-based literature I’ve found makes it sound like an easy game, but it is truly not. The only thing worse than playing a very difficult game is being mislead into thinking that the game you are playing is easy. This goes for the stock market in general, but especially option trading.