Lower Volatility Readings Tell Us A Great Deal

Many have expressed frustration with the VIX, or the volatility index. As you may know, this is simply an indicator which tells us about the demand for certain options. In this case, the SPX 500 options. When put options are in demand (looking for stocks to go lower), the volatility index expands higher. This is often when we hear the term ‘risk off’ trading day. On the other hand, when calls options (looking for stocks to rise) are in demand, the VIX tends to fall, and that encourages hungry investors/traders to buy up stocks without any regard for risk.

So, with the VIX currently ticking in around 21%, what is the historical significance and what does it mean?  Let’s do the math first. What a 21% vix implies is an expectation the markets will move around 1.3% per day, up and down. The higher the volatility number, the higher the expected move. When the VIX was at 32 for several days in 2022 for instance, the expected move each day was 2%. What is that move? With the SPX 500 at 4000, the expected move is about 80 points a day. No wonder traders and investors showed some exhaustion and weariness towards the end of the year.

We have also heard lately the VIX is broken or just doesn’t work anymore. That is comical, because this is simply an indicator. It tells us plenty of information. As for options, a reduced VIX tells us option prices are cheap. Why is that? The market expectations for a big move are not priced in currently, so a seller of options needs to reduce their price of puts and calls to attract buyers, which is the only way.  

Now, we hear each day about these zero day to expiration traders, or 0DTE. What are these people trading? Basically options that expire the same day! Why would anyone buy these calls and puts? These traders generally skip the time decay, but they need to get the direction correct or it’s a complete wipeout. Further, a big move outside expectations (such as Friday Feb 24) could be a good payoff for a short term bet. With volatility low as mentioned above, the amount of defined risk (buying your option) is much lower than when volatility is elevated.

Lastly, the implied volatility of future options is very important. What is this? Simply put this is the expectation of a move in days based on the demand for certain options at expiration, the volume and open interest (amount of options outstanding). When we see a lower implied volatility reading, such as the SPY March 6th expiration options with implied volatility at 17% we know the market action is likely to be tight, options are not pricing in a big move. In this way, options prices are very efficient in predicting moves.