Interested in options? Here’s how you can use VIX to time your trades.

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Subscribe to enjoy similar stories. Warren Buffet once said that an investor should be fearful when others are greedy and be greedy when others are fearful. The famous value investor was talking about the equity market, but it turns out this applies even more to the options market.

That’s because we can directly observe fear and greed in the options market, and profit from it. In 1993, the Chicago Board Options Exchange launched the market volatility index, aka VIX. This index tracks the implied volatility of options on the US stock market index.

It is commonly referred to as the ‘fear index’. Following its success, the National Stock Exchange launched the India VIX in 2008. This tracks the implied volatility of options on the Nifty stock market index.

What exactly does this VIX tell us? What is implied volatility in options? A basic feature of option prices is this: when the volatility of the underlying asset goes up, the option prices go up. That’s true for both calls and puts. Here’s a simple example that explains why.

Imagine a stock is worth 100 today. Next month it will be worth either 90 or 110 with equal probability. What is the value of a one-month call option on the stock with a strike of 100? Well, the call is worth 0 if the stock falls to 90 and is worth 10 if the stock rises to 110.

Thus, the call is worth 0 or 10 with equal probability, so its fair value today is 5. Now suppose the stock is more volatile. It is still worth 100 today, but next month it will be worth either 80 or 120 with equal probability.

Now, the call is worth 0 if the stock falls to 80 and is worth 20 if the stock rises to 120. Thus, the call is worth 0 or 20 with equal probability, and its fair value today is 10. Also read: How you can