Many traders have expressed frustration with the VIX, or the volatility index, lately because it’s showing lower volatility in the markets. It’s just an indicator, telling us what’s happening in options markets. So let’s dig into what’s going on behind the scenes.
The VIX tells us about demand for options
The VIX provides us with information about the demand for SPX500 options. When put options are in demand, it’s expected that stocks will go lower. In this scenario, VIX readings move higher. (This is often called a “risk off” trading day.) On the other hand, when call options are in demand, it’s expected that stocks will move higher. In this scenario, readings move lower – and hungry investors/traders buy up stocks without any regard for risk.
Right now, the VIX is ticking in around 21, which means that markets are expected to move around 1.3% per day (both up and down). When the VIX was at 32 for several days in 2022, the expected move each day was 2%. So, the higher the volatility reading, the bigger the expected move.
If the SPX 500 is sitting at 4000, a 2% expected move is about 80 points each day – that’s a lot. No wonder traders and investors were exhausted towards the end of last year!
So what does lower volatility mean?
Two things. One, lower volatility readings tell us that option prices are cheap. When the market doesn’t expect big moves, options sellers need to reduce the price of puts and calls to attract buyers.
Two, the market isn’t expected to swing higher or lower any time soon. That’s because current option prices tell us the implied volatility of future options (this is based on demand for certain options at expiration and the volume and open interest (amount of outstanding options) of those options). If little volatility is expected, options prices are low.
When you see a lower implied volatility reading, such as the SPY March 6 expiration options with implied volatility at 17%, you know the market action is likely to be tight. In this way, options prices are very efficient in predicting moves.
This doesn’t mean you should become a “zero day to expiration” trader, or 0DTE! They are basically day traders, but instead of trading stocks, they are trading options that expire the same day. If they fail to predict the option’s correct direction, it’s a complete wipeout. Sure, a big move outside expectations (such as Friday, Feb 24) could provide a good payoff for a short term bet. But why take the risk?
Back to the point of this article: Lower volatility is telling us that daily markets movements are expected to be small. But don’t be complacent. Continue to pay attention to price and volume to make solid trades.