Ball players live by a simple rule: “Keep your eye on the ball.” But as stock investors, we should all keep our eyes on the CBOE Volatility Index (VIX), aka the “fear index.”

Volatile markets are not just difficult to trade; they’re just not fun at all. Unless of course, you know what causes volatility and how to use that knowledge to your advantage.

In this article, and as I describe in more detail in my bestselling book Options Trading for Dummies, I will not only give you a glimpse into what causes volatility, but offer pointers as to how you can make volatility work for you.

What is volatility?

Let’s start with a working definition of volatility, which is nothing more than a measure of the variation of prices during any given time. In other words, a day in which there is a 500-point swing in the Dow Jones Industrial Average is a day of high volatility, whereas a 25-point day, up or down, is one of low volatility.

And for all intents and purposes, that’s all there is to it.

How do we measure volatility?

For sure, we can eyeball volatility, as I noted directly above. But it’s hard to trade consistently without some benchmarks or a plan. And a useful metric is the VIX, which through a complex formula based on options and futures prices predicts the future volatility of the S&P 500 index (SPX).

Generally speaking, falling levels in VIX point to decreasing volatility, while a rising VIX suggests higher volatility is ahead. The key is to look at the trend in VIX, not necessarily, or exclusively, the actual value.

Moreover, as the chart directly below shows, it’s important to see what happens to the S&P 500 in respect to what VIX does.

What the chart shows is that generally speaking, rising volatility, as measured by a rising value of VIX, usually means lower prices in SPX.

As any investor knows, when SPX rises or falls, so do most stocks. As a result, what happens between SPX and VIX is important to anyone’s stock portfolio.

Why does VIX make SPX fall?

Here is a hint: the inner workings of the relationship between VIX and SPX are not just related to a formula but actually deal with the inner workings of the options market.

In fact, what makes VIX jump is a rise in put option volume.

Put options are bearish bets, or options that investors buy when they start getting nervous about the market.

But there is much more to it than that because whenever anyone buys a put, someone has to sell the put to them. And in most cases, the put seller is a market maker.

Now here is the key.

When a market maker sells a put, he has to hedge his bets by selling stocks and stock index futures. He does this in case the put buyers are right in their fear.

As a result, he has to hedge to prevent being caught on the wrong side of the trade when the put options he sold to investors expire.

When investors get bearish and buy puts, it actually becomes a potentially self-fulfilling prophecy because the market makers accelerate the trend with their hedges, and that in turn makes the market fall further.

How does this knowledge help investors?

Here are several tips for volatile markets:

• Keep tabs on VIX and SPX on a regular basis; this may help you to get ahead of the crowd when trends change.
• Use option strategies to manage risk:
  • Rising volatility offers great opportunities to sell options for income, whereas
  • Falling volatility often delivers great option buying opportunities.

Getting Granular

Specifically, in this article, I want to explore selling options during times of high volatility.

Say you bought XYZ stock at $40 when VIX was low three months ago and XYZ has risen to $50. But suddenly volatility is rising and XYZ falls, but is trading around $46. You don’t want to sell it because there is no negative news on the company, and the most recent earnings call was very upbeat and included very positive future guidance for earnings.

At the same time, though, you’d like to protect your current gains as you wait to see what happens next.

In this case, you can sell a covered call with a $50 strike price with less than 45 days to expiration. And here is why:

Let’s say the option premium is $2. That means that if the stock stays below $50, you will likely keep the $200. That’s money in your pocket. This scenario works best if the stock stays between that $46-$50 range.

Moreover, if the stock rallies and gets above $50, you’ve got two choices. Keep the stock and see if you are assigned, or you can always buy the option back and continue to own the stock. This scenario is ideal if the stock blasts above $50 and rises for a while.

The point is that you didn’t panic even though VIX was rising and you got paid for being patient.

And here is a final thought. Selling options with 45 days or less to expiration is ideal because if the stock goes nowhere or falls, the time value of the option will decay faster and the odds of you keeping the premium rise.

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