By John Summa, CTA, PhD, Founder of OptionsNerd.com

Like with other measures of market sentiment, implied volatility (IV) can be used to gauge how extreme investor moods have become and to better anticipate major market turning points. In this segment of the options volatility tutorial, we'll present some examples of how IV levels, using the CBOE Volatility Index (VIX) index, relate to past and future price moves.


While the examples presented here are weekly close prices, higher frequency analysis can be applied as well. That is, VIX or IV levels on stocks can be tracked in shorter time frames (including intraday) to identify short-term oversold and overbought conditions, where reversions to a short-term mean of implied volatility frequently occur. Therefore, applying a contrarian approach has the potential to yield above-average returns.


IV as a Measure of the Investor Crowd
The VIX index is a popular gauge of investor moods and, as seen in Figure 18, can swing wildly quite frequently. It measures how expensive the options on the S&P 500 stock index are. You can find historical data available for download at the Chicago Board Options Exchange (CBOE).

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Figure 18: VIX implied volatility index since 1990. Note the extreme spikes above 40 during the worst periods of the bear market during 2000-2002. VIX rises sharply as investor fear intensifies.

When investors are fearful, and markets are bearish, VIX will rise. When fear recedes, VIX declines. However, long-term low levels of the VIX have been associated with bull markets, where VIX at extreme lows signaled a major market advance, as seen in Figure 19. In 1994 and 2004, VIX remained below 20 and the market developed significant bullish trends. (To learn more, read Getting a VIX On Market Direction.)

Introduced in 1993, VIX has grown to become one of the most popular gauges of investor sentiment and the volatility of the stock market. VIX is a measure of implied volatility, capturing the market's expectation of 30-day volatility implied by the near-term options on the S&P 500 Index. (For more on this, see Volatility - The Birth Of A New Asset Class.)

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Figure 19: S&P 500 alongside levels of VIX. Here it is possible to see how price and volatility relate to each other. Typical of most big cap stocks that mimic the market, when price declines, volatility (VIX in this case) rises and vice versa.

VIX reacts to sharp drops in the S&P 500, as seen in Figure 19. During each of the major market meltdowns (1997, 1998, 2001, 2002), VIX ran up sharply, signaling a market bottom was near. While VIX was created in 1993, because options have traded since the early 1980s, it was possible to back-build the VIX index (see the CBOE's website for a complete downloadable history). During the 1987 market crash, the VIX increased to levels above 100, hitting an intraday level of 172.79 on October 20, 1987. This number is based on S&P 100 options, not S&P 500 options. The VIX methodology was changed in 2003 to use S&P 500 options instead of S&P 100 options.



Because VIX has a long-term trend cycle to it, however, the best way to view the VIX is with moving averages. Figure 20 presents VIX with moving averages (10- and 50-day moving averages), which allows for better identification of short-term extreme levels when markets are overbought or oversold, irrespective of any longer term levels.
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Figure 20: Daily VIX and S&P 500 price charts. When the VIX 10-day moving average moves too far away from the 50-day moving average, the S&P 500 typically experiences a correction, as indicated by the small black arrows.

As seen in Figure 20, spikes of the VIX are smoothed with a 10-day moving average. As the 10-day moving average moves above the 50-day moving average, the market conditions are clearly turning bearish. And as the 10-day moving average moves below the 50-day moving average, the market conditions are clearly turning bullish. But when the deviation of the 10- and 50-day is stretched (different measures can be used to define "stretched"), a reversion to the mean occurs as the 10-day moving average returns back to the level of the 50-day moving average. This cycling of sentiment is a good contrarian indicator and can be used for better timing of market swings.

Conclusion
In this segment of the volatility tutorial, the VIX implied volatility index for S&P 500 index options is explained and presented. It was shown how the two indexes (VIX and S&P 500) move inversely and that with the application of different moving averages to daily VIX prices, it is possible to identify overbought and oversold regions of the S&P 500. This contrarian method provides a basis for better timing of the market for investors.

Next: Options Volatility: Conclusion »

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