Using Volatility to Measure Fear
Although it’s hard to believe, fear is a stronger emotion that greed. Thus, panic is more dramatic. It makes options market participants generally head for the exit much faster than what you see when they are committing new money to stock positions. The result is that markets generally fall much faster than they rise.
This can be seen with increased volatility as daily and weekly price swings move in a larger range. Using volatility sentiment measures helps you recognize declines that are nearing exhaustion.
Volatility really just gives you information about the price range for a particular security. You can use a variety of trading periods to calculate an annualized value allowing you to compare movement for different securities. Historical volatility (HV) can be plotted on a chart, enabling you to view trends and gain a sense of how current HV stacks up to periods.
Implied volatility (IV) is an option pricing component that is referred to as a plug figure. It’s the volatility level that accounts for the current option price after all other, more tangible pricing factors (that is, price, time, and interest rates) are valued. IV incorporates HV because it’s reasonable to expect the stock to move in a similar manner to the past, but not necessarily the same.
IV can also be plotted on a chart, allowing you to view trends and relative levels. Such charts highlight strong seasonal tendencies for certain stocks.
Recognizing impact from changing volatility
You want to understand IV so you can make the best decisions when buying and selling options. It can be advantageous to buy options when IV is relatively low and sell them when it’s relatively high, but there are no guarantees that seemingly low or high conditions won’t persist.
Clearly there’s always a chance of being wrong about the direction of an index or stock (two out of three really), but generally:
When IV is relatively low and increases quickly, it adds value to both calls and puts.
When IV is relatively high and decreases quickly, it decreases value for both calls and puts.
Pending news and reports, along with unexpected events, can spike IV. After the news or event is in the past, and an initial reaction occurs in the stock, IV declines as quickly as it spiked. Changes in IV that are more gradual may also occur, in either direction.
Spelling fear the Wall Street way: V-I-X
VIX stands for volatility index. It is a blended implied volatility value calculated using specific S&P 500 Index option contracts and is used as a sentiment indicator. You may have heard references to the VIX by market analysts commenting on conditions. The CBOE publishes the VIX closing values daily. Because VIX is an optionable index, trading programs graph the values in real time.
Because statistical volatility usually climbs when securities decline, you should expect IV to increase too. By viewing the VIX and SPX on the same chart, you can see just how often it does. The following holds for VIX readings:
A climbing VIX reflects bearish conditions in SPX and typically the market as a whole.
A declining VIX reflects neutral to bullish conditions in SPX and typically the market as a whole.
Overly bearish sentiment is reflected by high VIX levels. Eventually the bearish fear is exhausted, a reversal in stocks occur, and the VIX declines
The VIX was previously calculated using the S&P 100 (OEX) Index. This former VIX measure can be accessed using its new symbol: VXO.
The figure displays a weekly chart for VIX with an SPX overlay.
The relationship between the two indexes appears pretty strong when viewed together. The two are negatively correlated, so when SPX goes down, VIX goes up, and vice versa. Look for VIX reversals to confirm market bottoms.
Two other stock indexes with implied volatility data to watch include the Nasdaq Composite Index (COMPQ) and the OEX. The corresponding volatility indexes are VXN and VXO, respectively.
When viewing a chart for the VIX, readings prior to the revised SPX methodology are constructed using historic data.