Covered Call Writing And The VIX

 |  Includes: SPY, VXX
by: Alan Ellman

In my books and seminars I discuss determining market tone before making any investment decisions. One of the main factors I utilize in this evaluation is the VIX. I use this mainly to assist in determining the best choice for strike selection.

The VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index, which is a measure of the implied or expected volatility of S&P 500 options over the next 30 days. This implied volatility is reflected in the premiums paid for the options. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge".

There are three variations of volatility indexes: the VIX tracks the S&P 500, the VXN tracks the Nasdaq 100 and the VXD tracks the Dow Jones Industrial Average. I prefer the VIX to get a broader view of the market volatility.

The VIX is a useful indicator for short-term investors including 1-month covered call writers. Generally speaking, as market volatility increases the market values will diminish and vice-versa. The VIX is said to have an inverse relationship with the S&P 500. If we see a declining VIX or one that is remaining stable at a low level (below 30) along with an appreciating S&P 500, we have a favorable environment for selling covered call options. Here is a chart showing the inverse relationship between the VIX and the S&P 500 over a 3 month time frame:

Click to enlarge
(Click to enlarge)

Inverse relationship between the VIX and the S&P 500

The red arrows highlight areas when the VIX was declining and the S&P 500 was appreciating and the blue arrows show just the opposite.

Conclusion: The inverse relationship between the VIX and the S&P 500 is not 100% accurate but it does add information that will help guide us in our investment decisions like strike selection for example. With a favorable VIX and a positive technical chart for the S&P 500 I am more likely to favor out-of-the-money strikes. I also may be inclined to roll out and up as opposed to just rolling out as an expiration Friday exit strategy. In other words it will put me in a more bullish stance when making my final investment decisions. As with all other technical tools the VIX should be used in conjunction with other fundamental, technical and common sense indicators.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.