The VIX
The Chicago Board Options Exchange’ volatility index (VIX) reflects the implied volatility of OEX options. It is computed by looking at the premiums of the at- or near-the-money options, and taking a sort of average.
It is the same computation I use to calculate the implied volatility shown in the Implosion and Explosion lists. These are just VIX using the options on the stock or futures rather than options on the OEX. The exact computation is not important, but your image of the VIX is.
You can think of the VIX as a measure of the enthusiasm traders have for options. If the VIX is high, traders have pumped up the premiums they pay and demand for options; and if the VIX is low, traders are buying and selling the options for less premium than usual.
If the VIX increases suddenly, option premiums increase on average, both calls and puts. Traders have pumped up the prices at which the options are traded. If the VIX decreases suddenly, traders have suddenly taken the air out of option premiums, and the options cost less relative to their theoretical value than before.
When you purchase a call on the OEX, you are in reality making two bets: one on the direction of the OEX and one on the direction of the VIX. If both the OEX and the VIX increase, your call purchase will be profitable. But if the OEX alone increases, a profit is not certain. If the OEX increases but the VIX decreases, your option purchase can actually be a loss. I will give examples of this next week.
Likewise, if you sell a call, you are making the same two bets, on the OEX and on the VIX. If the OEX decreases and the VIX decreases, your call sale will profit. But if the OEX decreases and the VIX increases, it may not. And if you called the market wrong and the OEX actually increases but the VIX decreases, you might not lose at all–the decrease in the VIX may offset the loss from the OEX decline.
Thus, if you trade options of any kind, you should perform some analysis of what you think the VIX (or the implied volatility of the underlying in the case of non-OEX underlyings) as well as the OEX or other underlying.