Stock options strategies, including covered call writing, factor in a multitude of parameters including fundamental and technical analysis as well as many common sense principles. In my books, DVDs and seminars, I discuss determining market tone before making any investment decisions. One of the main factors I utilize in this determination is the VIX.
The VIX is the ticker symbol for the Chicago Board Options Exchange (NASDAQ:CBOE) 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. In our BCI methodology, we focus on the VIX because it gives us the broadest view of the overall market.
The VIX is a useful indicator for short-term investors, including 1-month covered call writers. Generally speaking, as market volatility increases the market pricing 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. Below is a chart showing the inverse relationship between the VIX and the S&P 500 over a 3 month time frame:
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. This relationship is reliable but not 100% accurate. However, it does add information that will help guide us in our investment decisions like strike selection for example. Like all other technical tools, the VIX should be used in conjunction with other fundamental, technical and common sense indicators.
A 6-month chart of the VIX and the S&P 500 shows an accelerating market benchmark and a declining VIX. More recently, the VIX has spiked as a result of disappointing earnings, and despite some positive economic reports. These factors would lead a conservative covered call writer to favor in-the-money strikes, low beta stocks and exchange-traded funds.
The VIX is a tool we can use to evaluate overall market conditions. It is never used by itself but rather in conjunction with other technical, fundamental and common sense parameters. It plays a valuable role in stock and strike selection.