Rules for Premium Selling Using the VIX
Why did IV drop in October despite falling stock markets?
- Implied volatility becomes less sensitive to down moves in the market if it is already high to begin with.
- When VIX is over 20, the size of its percentage change is roughly two- or three-times less than it would be if it was trading below 15.
- When VIX is already high, there is roughly a 1 in 4 probability of seeing VIX go down on a day where the market is also down—compared to just a 1 in 25 chance if VIX was low.
Even though stock markets have gone down in the second half of October, we also have seen implied volatility (IV, also referred to as market fear) also move down. That is not supposed to happen. So why did it happen?
To answer that, we must first understand how IV moves based on its current level. When the CBOE Volatility Index (VIX) is below 15, a 1% drop in the stock market leads to a larger spike in the VIX compared to when the VIX is above 20.
The probability of the VIX closing lower on a down day in the stock market is significantly higher when the VIX is above 20 compared to when it is below 15. In summary, implied volatility becomes less sensitive to down moves in the market when volatility is already high to begin with. This mini-study serves as a reminder not to get complacent with position sizing when volatility is low.
Fundamental rules for premium selling
Those selling premium need to mind the following rules:
- When IV is low, you aren't collecting the same amount of credit compared to when it is high, and therefore, a seemingly small down move in the market could cause volatility to increase quite substantially.
- When IV is high a small move down in the market could result in a positive profit/loss day for you even if you are short premium. This translates to seeing a higher risk of selling premium when IV is low simply because it tends to spike hard for nearly all down moves in the stock market.
The fundamental explanation of this phenomenon is to remember that implied volatility reflects future expected risk. If the current expectation is "high risk," but then you see a small down day, that move fails to exceed the current risk expectations and therefore the new expectation is lower. That is essentially the same thing as the IV going down.
Anton Kulikov has a decade of trading experience. He leads research content creation at tastylive, appears on over 20 live shows including Futures Power Hour, Options Jive, and Research Specials LIVE co-authored bestselling investment strategy book Unlucky Investor’s Guide to Options Trading, and contributes research content for Luckbox Magazine.
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