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Page 1 February 2010
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r> DiscoverOptions Letter
> Viewing and Using the VIX Premium Indicators By Len Yates
> Option Strategy of the Month: Long Iron Condor
In ThisIn ThisIssue...Issue...
Steve LentzDirector of Education
Dear Options Trader,
On January 13th of this year, I met online with severalDiscoverOptions mentoring students and we discussed Len Yates's VIXPremium indicator.
What a great session!
Len created the $VXX indicator in OptionVue 6 to reflect the extentthe $VIX futures are priced above or below the $VIX itself, i.e. at apremium or a discount. Extreme levels can be a good indication ofan impending market top or bottom.
Now, Len had written that a 4-day average $VXX reading of over 2.5is often indicative of a soon-to-occur market top. And since the $VXXhad recently climbed to 2.83, our discussion revolved around timingthe bearish entry, what option strategy to use and what stops wouldbe appropriate.
Look at the chart for the SPX on the following page and see whatgood that timing it was.
Although I cannot represent that every student who traded this signalmade money, I can certainly assure you that every mentoring studentin attendance learned something.
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Page 2 February 2010
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rTo watch the meeting yourself, go to: http://www.discoveroptions.com/public/pages/education/archived_webcasts.html.
If you would like more information regarding the $VXX indicator, pleaseread Len Yates’ article in this issue.
Best Regards,
Steve LentzDirector of Education
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By Len YatesPresident and Founder
The VIX (CBOEVolatility Index) is a measure of theimplied volatility of S&P 500 indexoptions and is a popular index foroptions traders to follow. A highvalue corresponds to a more volatilemarket and therefore more costlyoptions, which can be used todefray risk from this volatility by sellingoptions. Often referred to as the fearindex, it represents one measure ofthe market's expectation of volatilityover the next 30-day period.
At OptionVue we have createdproprietary indicators related to theVIX (available to all clients in theOptionVue 6 software). We start by
calculating a VIX Premium, which isthe amount by which the price of ahypothetical 30-day VIX forwardprice (derived from VIX futuresprices) exceeds the VIX itself. TheVIX futures 30-day forward price iscomputed by taking the weightedaverage of two futures contractprices - the contract expiring short of30 days and the contract expiringbeyond 30 days.
If the implied futures price is greaterthan the VIX, then the "VIX premium"is a positive number. If the impliedfutures price is less than the VIX, thenthe VIX premium is a negativenumber (and therefore not at apremium at all, but rather adiscount).
The first indicator we use is the VXX(using the symbol $VXX in OptionVue6, which gives a current quote andhas a historical price chart available
as well). The$VXX iscomputed bysubtracting theVIX from theinterpolated 30-day VIX futuresprice, thenadding 100. Anegative VIXpremium isbullish, while apositive VIX
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VIEWING AND USING THE VIXPREMIUM INDICATORS
Figure 1
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r(continued from Page 3)
premium is bearish.We add a factor of100 before storingand broadcastingthe number so thatit will always be apositive number andcan be sent throughour quotes system asan ordinary price(Figure 1).
There is the questionof just how positive or negative theVIX premium must be in order toconstitute a signal. This is up toindividual interpretation, but the mostextreme levels have given accuratesignals in the past. This indicator canbe relied upon to accurately callintermediate term bottoms, plus someof the intermediate term tops.(Intermediate term, here, means aperiod of several months.)
Though it may seem like this would betaking the difference between twoitems in different time frames, it isactually comparing two items in thesame time frame, because aninterpolated 30-day VIX futures pricerepresents the expected VIX price 30days from now, and the VIX isinherently a 30-day number. As aresult, the $VXX very simply compareswhat the futures market is saying to
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Figure 2
Page 5 February 2010
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rwhat the $SPX options are saying --looking 60 days out.
This approach came about as theresult of trying several differentapproaches to find the one thatseemed to make the most reliablesignals over the past two years. The$VXX makes very reliable signals, inmy opinion.
The second most valuable indicator isthe $VIX36, which compares $SPXoptions IV levels in a 60-day and 30-day time frame. It is derived bycomparing the 60-day VIX to the 30-day VIX. There is no published 60-dayVIX, so we compute it ourselves andpublish it as $VIX60. As for a 30-dayVIX, this is the highly popular $VIXitself. We calculate $VIX36 by dividingthe 60-day VIX by the 30-day VIX andthen adding 10.0 so that it will alwaysbe a positive number, again so wecan send it through our quote systemas an ordinary price (Figure 2).
The $VIX36 is to be interpreted asfollows: If above 10 - bearish, if below10 - bullish. Seen over history, extremevalues of the $VIX36 have beenalmost as valuable as the $VXX incalling turns in the market. Whenlooking at these indicators for a signalof a market top, it is advisable to usea 3 - 6 day average, because single-day spikes are not reliable. Also, theactual top often happens severaldays following the signal, so beaware of this possible lag effect. Onthe other hand, when using theseindicators for a signal of a marketbottom, it is best to use instantaneousreadings.
Now I would like to tell you whatsteps I take to view these twoindicators and how to interpret themto detect signals of possible markettops and bottoms. I compare a pricechart of the SPX (S&P 500 Index) witha 4-day smoothed $VXX value overhistory. All that matters is absolutelevels. Notice that when the $VXX
was high (i.e. at or above2.50), then it has signaledseveral important tops. Forinstance, in May 2008 theVXX was at 3.50, and lookat what the market didduring the next 8 weeks. Itdoes not matter that the$VXX held its high level foronly a few days. Once setin motion, the sell-off goesto completion.
The VXX can help youknow when the bottom
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(continued on page 6...)Figure 3: The $VXX at a high level, correspondingto an intermediate top in the market.
Page 6 February 2010
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rhas been reached with a reading inthe area of -3.50. However, whenwatching for a bottom it isimportant not to smooth the $VXX,but rather to look at instantaneousreadings. By the way, you'll noticethat the VIX premium indicatorswere showing wildly negativenumbers during the worst period ofthe crisis -- from 9/12/08 to 12/05/08-- and were useless during that time.I do not know why this happened orif it could ever happen again.
What the $VXX does during the sell-off does not seem to matter much.It can swing between +1.50 and -1.50 and do all kinds of things butthese movements do not seem tobe useful. In my experience, theonly things that matter are whenthe $VIX makes (and holds for afew days) an extremely high level(signaling a top) or when the $VXXis at an extremely low level(signaling a bottom). The VIX36also has value as an indicator andshould be interpreted in much thesame way.
The most reliable kind of trade youcan use with this information issimply to take a long term (i.e.approximately 8 weeks) shortposition and leave it on the wholetime. If you try to jump out atcertain times and back in atcertain times, you might be ableto achieve better returns but youmight not. I enjoy trying to playthe daily moves, but I have toadmit that I do not alwayssucceed in enhancing my returnsby doing so.
Having said that, I want to bringyour attention to the remarkable"topping" signals that were recentlygiven by the VIX premiumindicators, first by the $VXX and thenby the $VIX36.
The $VXX was seen to havereadings in the area of +2.50 to+3.00 for several days betweenDecember 29th and January 8th.These are extremely high levels andmatch two similar instances back in2008 - both of which were followedby significant sell-offs lasting severalweeks. The persistence of thesehigh $VXX levels over a period ofseveral days is also significant, in myopinion. Therefore the $VXX hasgiven a definite signal to go short.
Following directly on the heels ofthat, the $VIX36 spiked to 11.65 onJan 11, 2010. This is the highest levelever seen during the history ofcollecting this index (since August2007). Such a high reading addsconfirmation to the bearish signalfrom the $VXX.
And now we see that the markethas actually begun to sell off. Thuswe will be playing this for furtherdownside until we see a signal fromthe $VXX that the selling is over(Figure 3).
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Page 7 February 2010
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rDiscoverOptions Personal Mentoring Program
Page 8 February 2010
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rThe Long Iron Condor is a strategyfor stocks that are range-bound.
It is in fact the combination of aBull Put Spread and Bear CallSpread. The combination of thesetwo income strategies alsoqualifies this as an incomestrategy.
Traders often will leg into the LongIron Condor, first trading a Bull PutSpread just below support, andthen as the stock rebounds offresistance, a Bear call Spread isadded, thereby creating the LongIron Condor.
To construct this positionyou need to: 1. Buy one lower strike (OTM) put. 2. Sell one lower middle strike
(OTM) put.3. Sell one higher middle strike
(OTM) call.4. Buy one higher strike (OTM) call.
All options share the sameexpiration date for this strategy,and there should be equaldistance between each strikeprice. The stock price shouldgenerally be between the twomiddle (sold) strikes.
Option Strategy of the Month - Long Iron Condor
Figure 1 (continued on page 9...)
Page 9 February 2010
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rIdeally the stock will remainbetween the two middle strikeswith the maximum profit occurringif all four options expire worthless,and you get to keep the creditreceived from placing the trade.
The investor writing a condorshould firmly believe the stock isnot going to move up or down alot in price!
If the underlying price moveshigher than the strike price of thecall sold, the seller will be assignedand required to sell the stock atthe sold call's strike price.
If the underlying price moves lowerthan the strike price of the put thatwas sold, the seller will be assignedand required to buy the stock atthe sold put's strike price.
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