Understanding The VIXC

If you spend a little time surfing around the Montreal Exchange site you will eventually make your way to the MX Indices tab. At the top of the menu you will find a link to the VIXC, which is the S&P/TSX 60 VIX or volatility index. The VIXC reflects the 30 day implied volatility of S&P/TSX 60 front month and next month options. Implied volatility is the component of the options price that reflects expected or anticipated movement in the underlying security. If a stock or an index is expected to trade with in a predictable range, implied volatility or IV tends to remain low. However, when there is an expectation of uncertainty or an element of risk introduced to the market, IV will increase. I try to explain it like car insurance premiums. If you fall into a low risk category and have a history of safe driving, your car insurance premium is low. If you fall into a more risky category or perhaps land yourself a speeding ticket, even though you have yet to get into an accident your insurance premium will increase. This is the insurance companies way of hedging against the possibility or probability of an accident.

If we think of option premiums in a similar way, it becomes a little easier to understand why the VIXC has negative correlations to the underlying market. As the S&P/TSX 60 begins to show signs of weakness or there is a broader market concern for risk, S&P/TSX 60 options, also known as SXO options, will be priced higher to compensate the option writer for the uncertainty.

Below is a snap shot of the VIXC. Note that the S&P/TSX 60 Index is in the red and a measure of the implied volatility of SXO options is represented in blue. You should be able to see the negative correlation clearly.

It is important to realize that each stock and their associated options will have their own comparative measure of implied volatility. The VIXC provides us with a good indication of market conditions in general, however we still must pay attention to the relationship between the historical volatility and implied volatility of individual stocks. This is due to the unique risks associated with certain companies that are not necessarily reflected in a market index.

With that in mind, we can use the VIXC to help us determine which strategies might be more effective based on the market conditions. For example, when the VIXC is in the low area of the range between 8.5 and 10, this represents a period of overall low implied volatility and options may be considered undervalued or fairly priced. This is a good time to be an option buyer from a pricing perspective. Keep in mind that this doesn’t mean you will necessarily be correct about your outlook, just that you have a reduced risk of loss due to a contraction of implied volatility. In addition, a closer look at the chart suggests that when the VIXC is at its lowest and the index is at it’s highest a market pull back may soon follow. I look at this as a sign of complacency in the market and a good time to consider buying protective puts or locking in some profits ahead of a potential sell off.

When the VIXC is in the high area of the range between 14 and 16, this suggests implied volatility is high and options may be considered expensive. During this period, option writers can collect a higher premium due to market uncertainty. In addition, traders who are considering taking a directional stance using options may consider using debit spreads as a way to offset the increased implied volatility.

Currently, the VIXC sits in the middle. This suggests option premiums are pricing in some risk and investors should consider this when looking to take a bullish stance on the market. Protective puts, collars and spreads are good considerations in this market environment. Close attention should be paid to the implied vs. historic volatility of individual stocks to ensure that the correct strategy is being used based on the observations.