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Option Prices and VIX

Last week was a bad one for the market.  Friday’s 2.5% drop was the worst day in all of 2012.  Many Terry’s Tips subscribers did just fine because of our 10K Bear portfolio which gained 23.4% for the week.  Over the past five weeks while the market has fallen 8.7%, this bearish options portfolio has gained a whopping 135%.  Once again, options offer opportunities that conventional investments just can’t deliver.

Today I would like to talk about an important options measure called VIX.

Option Prices and VIX

VIX is a measure of the average Implied Volatility of SPY, the tracking stock of the S&P 500.  It is often referred to as the “fear index.”  When investors get scared, they often buy put options and/or sell call options to protect themselves against a big market drop.  When this happens, VIX (and option prices in general) usually moves higher.

VIX almost always moves in the opposite direction of the market.  If the market moves higher, VIX usually moves lower, and vice versa.

On Friday, VIX closed at 26.66, driven higher by the big drop in stock values.  VIX is essentially the percentage change that the market is expected to fluctuate in a year.  The mean average of VIX is about 20, far less than it is today.  Quite often, when there is a sideways market with little volatility, VIX hangs out as low as 16.

Today’s high VIX number means that option prices are high.  It is the perfect situation for our strategy of selling short-term premium.  We love a high VIX.

When VIX moves higher, not only is it possible to collect more premium decay each week or month, but the entire portfolio made up of calendar spreads is likely to move higher as well.  This occurs because the long side of our calendar spreads (the options with more remaining life and therefore the ones with a higher absolute value) increase in value by more than the short-term options that we are short. 

If an option trading at $6.00 goes up 10%, the option will be worth $.60 more, while a short option covered by that longer-term $6.00 option might be trading at $.90, and it might only go up by $.09.  If you had 10 of those spreads in place, your portfolio would increase in value by $510 just because of the higher option prices that result when VIX moves higher.

Trading options is far more complicated than most investments.  If you are just buying stock or mutual funds, you don’t even have to know about VIX.  But we believe that there is a big payoff for making a little effort to learn about the extraordinary possible returns that an options portfolio can deliver if it is properly constructed.

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