Lately, the market's been all over the place. Some call it "range bound"; others call it "volatile". Whatever you call it, the market has been nothing short of erratic. For most investors though, getting a grasp on volatility can be challenging. In this article, we'll help clear things up a little bit.
Measuring Blood Pressure
First, there is a measurement of volatility in the market: the Market Volatility Index (VIX), which is a measurement of implied volatility for the S&P 500 futures. The futures are traded on the Chicago Board of Options Exchange.
What some fail to mention in an explanation of the VIX, however, is that it is not only a measurement of fear within the markets, but also gives insight to the cost of option premiums. As the VIX rises, fear is said to have increased in the market, along with the price of option premiums. After all, those who are writing options want to be compensated for the risk they are taking on.
And, if fear levels are rising, meaning the market could become more and more erratic, option writers (sellers) need more money, given the risk of their options expiring in-the-money. All of which would mean the option writers could lose hordes of money. (To learn more, see Gauging Sentiment With The Volatility Index.)
As a value, the VIX can trade anywhere between 5 and 100; however, the VIX may trade in ranges, based the market paradigms at any given moment. Check out this information:
Historical Heart Rate
From 1991 until later half of 1998, the VIX traded with an approximate floor of about 10, but never spent much time above 30. But then, as the dotcom era took over in the late '90s, the VIX found a new range trading from roughly 20 to 50. In 2002, spikes to 50 coincided with dramatic market lows.
Then, in 2003, the VIX once again fell below 30, and has traded in the 10 to 20 range ever since, with the exception of three spikes.
One of these spikes (up to 23.81) came in the early summer of 2006. In the three months prior to the VIX topping out in 2006, the S&P 500 lost 8% from the May high. Then, this past March, the VIX again spiked over 20 to 21.25. From February to March, the S&P 500 lost 6.7%, before recovering. Most recently, on August 9, the VIX spiked to a high of 26.90, and since the middle of July, the S&P 500 has lost 8.2%.
A New Paradigm
Are you beginning to see a trend here? Actually, let me rephrase that. Are you beginning to see the current market paradigm? If the VIX falls back below 20, the current paradigm could easily continue, and investors may want to look for new highs.
However, if the VIX fires above 30, it will the first time it has done so since 2003. A spike would not immediately mean the market is going to crash, but it would infer a new paradigm.
There's one thing I've learned in my years, the market constantly changes, and we MUST be aware of the trading paradigm the market is currently facing. Thus, keeping a close eye on the VIX's range (especially given that it's at a three-year high), could help clear the air on whether things are going to get more shaky, or fall back into the old bullish range. One thing is certain: exit is everything.
For further reading on the use of VIX as a market-timing indicator, see Getting a VIX on Market Direction.
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