The CBOE’s Volatility Index ($VIX) has been a stalwart for option traders and technicians since it was introduced in the early 1990's. The $VIX measures the implied volatility of $OEX options. However, in recent months, the trading in $OEX options has slowed dramatically, and many traders have forsaken them for the more active and volatile equity options – especially NASDAQ options. As a result, $VIX is becoming harder to interpret. Therefore, we thought that perhaps another Volatility Index could be constructed as a useful supplement to $VIX. It would be a “supplement” rather than a “replacement” because there may come a day when most speculators return to the $OEX market. If that were to happen, then $VIX would regain its former place as a premier measure of public sentiment.
Admittedly, option traders’ “hot” topics may sometimes be pretty boring to the average guy, but this question (above) has been the subject of much discussion amongst all manner of stock market analysts. Recently, the various volatility averages began to rise, even while the broad stock market was rising. This is something that hasn’t happened for a few years, and it also seemed to go against the “conventional” (and I should mention, incorrect) volatility analyses that one is often subjected to when watching financial TV these days. So, just what does this rise in volatility mean, coming as it does during a period of rising prices? That’s what we’ll explore in the feature article in this issue.
It is somewhat common knowledge amongst option traders that the CBOE’s Volatility Index ($VIX) can be used as a predictor of forthcoming market movements. In particular, when volatility is trending to extremely low levels – as it is doing now – it generally means that the market is about to explode. In this article, we’ll put some “hard numbers” to that theory and we’ll also look at alternate measures of volatility (QQQ and the $OEX stocks themselves) to see what they have to say.
No, this isn’t an expose, despite the article’s title. Rather, it is an attempt to set the record straight about how volatility levels can be used as a predictive market tool. So much has been written and said about volatility in the last few weeks – in main-stream publications and on national television outlets. Much of it is erroneous. These errors are not really attempts to mislead the public, but are rather outgrowths of conventional misconceptions. The misconceptions may have arisen out of an over-reliance on near-term trends, while ignoring or being ignorant of what a longer-term volatility picture actually means.
Most of the time, we look at index options in order to make general observations about volatility. These observations, which evolve into opinions, often involve $VIX, $VIX futures, or $VIX options, all of which are based on the $SPX options. This is a reasonable approach, of course, since $SPX options are heavily traded, as are the $VIX derivatives, and therefore they reflect the greed, fear, and anticipations of literally millions of traders.
We often refer to implied volatility and its uses. However, it's been some time since we actually discussed the use of implied volatility as a predictor of market movement. Consequently, we have received number of subscriber requests for this information and have decided to satisfy those requests with this article. The gist of this article is to use implied volatility as an impetus for directional trading — i.e., to use it to predict where the underlying market is going to go, and then to make an outright buy or sell in that market. This is as opposed to trading volatility itself, which is a neutral strategy (that theoretically doesn't try to predict the direction of the underlying market at all). This latter concept results in the type of strategy offered under "Trading Volatility".
We have written about volatility many times in the past, but the “best” use of $VIX is that it spikes up to a peak when the market is collapsing, and then comes slicing back down when the crisis – whatever it is – has passed. Recently, in Volume 13, No. 4, we showed the entire history of $VIX, including the hypothetical history back into the 1980's. It is evident from that chart that spike peaks in $VIX are major buying opportunities. On a short-term basis, minor $VIX peaks are also good buying opportunities. The reason that this is true is generally that traders rush in to overpay for put options (insurance) when the market is collapsing. Imagine how expensive hurricane insurance would be if you waited until the clouds were on the horizon before purchasing it. The same thing applies in the stock market. When put premiums are cheap, as they were for the last eight months, no one wanted to buy them, but when the market broke down – exacerbated by terrorist fears – many rushed in to buy what had become relatively expensive puts.
Over the years, we have written many times about the problems in predicting or estimating volatility. However, it is necessary to attempt the task, because it is so crucial in determining which (option) strategies can be used.
