Volatility Can Make You Rich Or Poor

Volatility, in simple terms, is a visual representation of fear and greed. As it relates to the stock market, volatility refers to an environment where prices tend to fluctuate beyond what is considered a “normal range”. Investors positioned on the right side that price movement can experience a large profit rather quickly. Similarly, an investor positioned on the wrong side of the price move may experience loss at a faster rate and larger magnitude.

The Stock Market Is A Jungle

We, as investors, can either become predators or prey in a volatile environment. Every investor enters the stock market with the hopes of earning a profit and making money, not losing money. Just the same, predators do their best to catch prey and not be caught themselves.

Crazy metaphor.

The purpose of this comparison is to make one thing very clear. Although we may want to be on the right side of an investment, volatility makes the environment much more unpredictable.

We, as investors, can either become predators or prey in a volatile environment. Every investor enters the stock market with the hopes of earning a profit and making money, not losing money.

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How Do You Know When There Is Volatility

To avoid becoming prey themselves, many large investors use a common tool to measure volatility: The VIX. The market volatility index, or the VIX, aims to measure the level of uncertainty and fear amongst market participants. By gauging this fear, we can position themselves to not be victim to sudden changes in the market environment.

This is an overview of the VIX, how it’s used, and why that matters to you.

VIX Overview

So what is the VIX? The VIX, Cboe Volatility Index, is a tool used to measure the market’s expectation of volatility, 30 days out. With it, Investors can measure the level of risk, fear, and stress in the market when making their investment decisions.

Fortunately, you don’t need to know the exact mathematical calculations behind any of it. I’m sure you can go look it up, however, all you need to know is it uses the S&P 500 index options, particularly the put option volume and demand (among other variables) to gauge the market participants’ fear . Because of this measurement of put option demand, the VIX is typically inversely related to the market. That means when the VIX goes up, the market typically goes down and vice versa.

Example of Volatility Correlation

When news of Covid really started to spread in March, the stock market plummeted and the VIX shot up, way above its upper bound.

Not just that, it shot up really quickly too. Anyone who missed the volatility signal from the Vix and had long positions would have been caught off-guard, and punished. Those investors who saw the sign, even if they were a little late, were able to profit enormously.

Important Numbers to Remember

When the VIX pushes past 20 and keeps going higher, that signals increasing uncertainty and risk. In response, the markets tend to start their decent to the downside. Conversely, VIX values below 20 and decreasing signals bullish and optimistic sentiment among investors. In this environment, where investors are not worried about much, prices tend to rise comfortably.

stocks for beginners volatility index

How Do You Make Money From Volatility

There will be many opportunities to make money for the investor that can notice changes overall market sentiment prior to price movement. As an investor, the tools we use allow us to read data based on part information with the hopes of anticipating future price movement. The volatility index is one of those tools.

The use of puts and covered calls are two very common strategies to make money in volatile markets when price moves down. On the other hand, if prices are going up then investors may choose to buy call options or sell put options. As a rule, the strategy you use should be in line with your level of experience with options trading.

Who Else Uses The Vix Volatility Indicator

The measurement of volatility in the stock market is especially important for its largest investors. Warren Buffet and his Berkshire Hathaway organization, Blackrock Management, and the largest banks in America are in possession of millions of shares of stock. The problem with that is, all of those shares can’t be sold that quickly in a volatile market moving to the downside. There has to be buyers to absorb the shares being sold, after all.

What Can Large Investors Do When They Get Bearish

If large scale investors are bearish on the market and they want to sell their stocks but can’t dump it because there won’t be enough buyers, what can they do? They buy put options. Put options are much cheaper to get into and out of than it is to leverage and get rid of a million shares of stocks. So they get into options. And as we already know with put options, you benefit from a decrease in price. So, when big money is bearish and they can’t sell all or part of their stock holdings, they buy put options to hedge their portfolio.

Not only do they want put options, they want to own enough options that are going up in value so that they’re not losing too much money on the back end.

Obviously that’s a super simplified explanation. But you get the idea.

When big money is bearish and they can’t sell all or part of their stock holdings, they buy put options to hedge their portfolio.

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Why The Vix Indicator Is Important For Retail Traders

As I mentioned above, investors holding massive amounts of shares will sometimes use puts to hedge their portfolio. When they begin buying puts, the Cboe volatility index goes up with the demand.

The Vix indicator helps us, retail traders, have an idea of what the large scale investors are feeling. You may not be able to see when and what these guys are buying and selling, but the Vix allows us to see if they’re at ease with market conditions or making big moves preemptively to protect their investments.

With that kind of information, we can make better investment decisions.

This is one way of finding out what the large investors and institutions are thinking, how they might feel about the market.

The Vix Is A Macro Indicator, Not Micro

Let me be clear, the volatility index isn’t telling you that all the large investors are buying puts. If they were all on the same page then the market would move in only one direction at a time, after all. Instead, it zig zags in a tug-a-war fashion as big money battles for supremacy. The market has inherent differences among big money investors. Still, when you see the VIX start to move quickly-you know there are bigger players at work in the put options market. 

How Should You Use The Volatility Index In Your Strategy

Using the VIX as a tool in your strategy isn’t so much about finding out exactly what the institutions are buying and selling.

What it does do is allow us to hypothesize whether or not fund managers and institutional investors are hedging their portfolio by adding put options to their balance sheets. By using that VIX tool in your strategy, you can decide whether or not you want to open or close long and short positions. Keep in mind, if the volatility index is screaming higher and you’re buying call options, you’re going against the professionals. Unfortunately, it typically doesn’t pay to go against the professionals. 

There’s a saying out there on wall street that if the VIX is high it’s time to buy. This suggests that if the VIX is high, there’s a lot of fear and possibly a lot of discounted stocks. And then vice versa. When the VIX is low, look out below. There’s not a lot of fear and possibly even an overly bullish sentiment. The phrase, “look out below” means you’re going to watch out for falling prices.

BOTTOM LINE

None of this is saying that when the Vix moves higher to switch immediately to becoming bearish and dumping your bullish positions immediately. No, it doesn’t mean you should stop being bullish. No, I just get prepared. One strategy could be to refrain from opening more bullish positions. Another strategy might mean investors should secure some profits. Without a doubt, I would preserve a cash position to potentially profit from a downside.

Full disclosure, I don’t look at the VIX every day. In fact, I rarely look at it but I’m always aware of it. Even if I’m bearish on the market, I’m going to continue playing bullish. That is, until I see other signals that lead me to change course.

There are many different ways to invest and make money in the stock market. However, it is also important to have a way to stay on the right side of the market in times of volatility. The volatility index, or The Vix, is the perfect tool to measure volatility for all investors.