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Volatility: A Breakup Tale

by | Jan 10, 2024

Another long holiday weekend is HERE — and Lance just so happens to be 6 for 6 over the MLK weekend. Get in on this week’s three trades!

Dear Fellow Trader,

I explained Tuesday the importance of earnings season.

With earnings can come volatility. You’ve probably heard of volatility, but no one took the time to deeply explore what it is and why it’s so important to traders like us. So, in the spirit of going back to basics, we’ll dig into what volatility is, why it matters to our options trading, and how you can exploit it.

Let’s dig in…

The Definition of Volatility?

Volatility refers to the degree of variation in the price of a financial instrument over time. So, when there’s significant volatility in stocks or other assets, there are more frequent price swings.

High volatility indicates larger and more frequent price swings, while low volatility suggests relatively stable and predictable price movements. We are currently in a low-volatility environment, but things could change quickly during earnings season.

So, what drives volatility?

A lot of things… It can be macroeconomic events like war. It can come from market sentiment, geopolitical developments and company-specific news. And there’s no bigger “company news” event than earnings.

Volatility is critical because if it increases, it heightens risk. And that can impact your portfolio’s performance. In the world of momentum, a Red signal for our Equity Strength Signals tends to accompany periods of high volatility.

Tracking Volatility

We track volatility using what’s known as CBOE Volatility Index — or the VIX. CBOE stands for Chicago Board Options Exchange, the location where the overwhelming bulk of options trading happens.

People call the VIX the “fear index,” but I’ve always viewed that as a bit of a misnomer.

We measure the VIX by looking at the prices of S&P 500 index options, so it’s not measuring the performance of smaller-cap stocks. And that’s important. Our Equity Strength Signal is based on the Russell 2000 because it better represents investor sentiment, has far less exposure to passive investing, and is closer aligned with the underlying U.S. economy.

Where it is successful is that it measures the purchasing of put options. When investors are worried about potential market turbulence, they tend to buy more put options — which increase in value when the market falls — driving up their prices and, in turn, the VIX.

The VIX tends to fall when investors are more optimistic and believe that market volatility will remain low. People are buying fewer puts, and the cost of these puts declines.

And that brings me to my final point. Volatility impacts options prices.

How Volatility Impacts Options Prices

Options are financial derivatives that get their value from an underlying asset. So, the price may be based on a stock, index or commodity. Volatility plays a significant role in determining the prices of options and is a crucial factor in option pricing models.

There are three ways that volatility impacts pricing.

First, higher volatility drives options premiums (prices) up. When the underlying asset is more volatile, the option is more likely to move in the money (profitable) before expiration. Options with higher implied volatility tend to have higher premiums. Traders and investors are willing to pay more for these options to benefit from potentially larger price swings.

Second, lower volatility decreases option prices: Options on assets with lower implied volatility have lower premiums. This is because the probability of significant price moves is reduced in a less volatile market, making options less valuable.

But here’s the really important point…

The VIX, as a measure of market volatility expectations, directly influences the pricing of options. When the VIX is high, options across the board tend to be more expensive because market participants anticipate greater price fluctuations. When the VIX is low, options are generally cheaper.

A VIX score of 20 is considered average volatility — a 1% move up or down in a given day.

Right now, we are in a VERY low volatility environment at just under 13 on the VIX. But things can heat up quickly. That’s why we have to pay very close attention to the VIX, and look for a possible breakout on the index. If the VIX rallies, we could see a big drop in the S&P 500. The Russell 2000 has already taken a hit this year. We’ll see what happens with the banks reporting on Friday.

Chat soon,





Garrett Baldwin

*This is for informational and educational purposes only. There is an inherent risk in trading, so trade at your own risk.

P.S. Check Out This ProTrader Dashboard Demo

Did you catch Roger Scott’s final ProTrader Dashboard LIVE Trading Workshop today?

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*The profits and performance shown are not typical, we make no future earnings claims and you may lose money. Since the ProTrader Dashboard is a tool for traders and not a trading service, profits and performance will vary among users.Trade at your own risk.



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The material in this document is for informational purposes based on our proprietary research. It is not an offering, specific recommendation, or a solicitation of an offer to buy or sell any securities mentioned or discussed herein.

Any performance results discussed herein represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Due to the timing of information presented, any investment performance reflected within this document may be adjusted after the publication and distribution of this material. There can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this communication will be profitable, be equal to any corresponding indicated historical performance levels or be suitable for your portfolio.

Any investment results set forth in this document are not net of expenses and execution costs, nor do they account for other relevant trading or investment fees. Please visit thetradingpub.com/terms-of-service/ for our full Terms and Conditions.

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WRITTEN BY<br>Garrett Baldwin

Garrett Baldwin

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