This commentary originally appeared on Real Money Pro at 13:00 on Feb. 19, 2016. Click here to learn about this dynamic market information service for active traders.
Emotionally-related chaos, especially the type of chaos that enters the markets, expands time. The opposite of chaos, that being "order", contracts time.
When trading at-the-money or out-of-the-money options, what we really trade is time relative to volatility and the price of that volatility relative to the time left to expiry. We are trading only time and not any form of equity when trading any option not in the money by even one penny. And since the vast majority of options that are traded are not worth even one penny of equity, understanding as much about volatility as possible makes for very important option trading-sense.
Volatility and the price of stocks and their options combine in only four ways. Those four combinations are:
1) VIX (and thus VXX) rising and stock prices declining.
2) VIX (and thus VXX) rising and stock prices rising.
3) VIX (and thus VXX) falling and stock prices rising.
4) VIX (and thus VXX) falling and stock prices falling.
The CBOE Volatility Index (VIX/VXX) rising and stock prices declining is the big one, the headline grabber when volatility rising becomes a euphemism for fear in the markets. Never do the talking heads report that in this type of environment the pros are raking in the dough about as quickly as the dough is on the table to be snatched up. This stupidity of financial news reporting is right down there with using the dopey phrases "risk on" or "risk off" -- as if the only risk that is on or off is retail risk relative to stock prices rising or not.
In other words, many pros have risk on when they are short the market, and risk off when the market is rising. Oh, and those pros make a lot of money shorting the market with risk on.
The VIX/VXX rising and stock prices rising is quite rare, but should never be fought like in fighting the tape type of fought. For proof of that statement, just do a bit of homework and see how the VIX went up and up and stayed up from 1995 into 1996 as the dotcom market hit its stride.
The VIX/VXX falling and stock prices rising is a normal combination. Those same talking heads, when catching on to this fact, say fear is coming out of the market. Well, d'oh.
The VIX/VXX falling and stock prices falling is a very ephemeral combination, because it tends to occur at the bottom of a serious stock market decline that has not quite exhausted itself, but is what I call floundering around. It is a market that will be reported as one that is fishing for a bottom. It is the period when the buyers are still scared if not scarred, and the sellers are long gone and sold out, while the pros have covered their shorts and dare not push their profits adding new shorts.
That's it! There are no other combinations.
One more point. I chart the VIX (and thus VXX) as if it is a stock, using a one-year chart. If I seriously like or dislike the pattern, I then ask myself which of these four possible combinations probably lie just ahead, due to the coming change in the value of the VIX/VXX as per its chart pattern.
Understanding these combinations and what they imply for the underlying stocks, stock indices and ETFs is a major advantage and thus give an edge to any trader and investor.