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Volatility and the Stock Market
Stock market volatility can be defined as the degree to which the market goes up and down and up and down. Sounds pretty simple, right? Well of course there is a lot that goes into market volatility, and while we won’t address in depth factors that lead to market volatility here, we will instead focus on indicators that can help us determine where the market is headed.
Some say that market volatility is a measure of investor nervousness, and while there may be some truth to that, most investors are professionals that are lead more by fact than by fear. At least we can hope this is true. Another misconception is that a market going up, up, up is a volatile one, well, that just simply is not true. Volatility if a measure of the speed in which the market goes up and down, up and down. So a market which slowly goes up, up, up over the course of time is seen as having very little volatility.
How is volatility measured and how can we use it to our advantage? In 1993, the Chicago Board Options Exchange (CBOE) introduced the CBOE Volatility Index, known as the VIX. Originally it was designed to measure the market’s expectation of the 30 day movement of the at-the-money S&P 100 Index (OEX) option prices. In 2003, the CBOE updated the VIX so that it better reflected the movement of the overall market. As of 2003, the VIX is based on the S&P 500 (SPX) index option prices. The VIX estimates expected volatility by averaging the weighted prices of SPX puts and calls over a wide range of strike prices. If you are interested in learning more about how the VIX is calculated you can find the mathematical formula on the CBOE website at www.CBOE.com. In February 2006, CBOE launched VIX options which, since inception, has grown to more than 100,000 contracts traded per day.
All options used to calculate the VIX are either in the front month (nearest to expiration) or the second month. Technically, the VIX estimates the implied volatility of what an at-the-money option on the S&P 500 would be with 30 days left till expiration. The VIX is quoted in numbers between 0 and 100 and normally trades at the lower part of that range. Lets look at an example. On March 11, 2010 the VIX was trading at 18. That number represents the movement – both up and down – that could be anticipated in the S&P 500 over the next 30 days. What that means is, based on implied volatility in the S&P 500 options, the index is expected to move approximately 1.5% (the VIX at 18 divided by 12 months) over the next 30 days. Okay, that’s interesting, but how do I make use of the that information? What that means is that within the next 30 days you can project that the S&P 500 will move 1.5% either up or down. It gives you a range in which you can expect the index to move. Using our example of March 11, 2010, the S&P 500 closed that day at 1150. Option traders and investors anticipate that between March 11, 2010 and April 10, 2010 the S&P 500 is likely to trade between 1132.75 and 1167.25. Of course that doesn’t mean the S&P 500 will actually trade in that range just that investors and traders anticipate that to be the case.
Keep in mind that the value of the VIX is constantly being changed and is only a measure of the expectations of traders and investors. Historically speaking, a very low VIX is an indicator that the market is ready for a sell off, if the VIX is high, that indicates a rally. Others argue that while that used to be the case, in today’s market there are so many other factors that influence market movement that the past behavior of the VIX is a poor indicator of where the market is headed. In either case, the VIX is just another tool in your toolbox to help gauge movement in the market.
One important thing to also know about the VIX, it’s expiration schedule. The VIX typically expires on the 3rd Wednesday of the month, but that is not always the case. If you are actively trading the VIX, please consult with a VIX expiration calendar so you are not caught unaware of the actual expiration date. Just Google “VIX expiration calendar 2010″ and you will find the current schedule.
While this article has primarily dealt with the VIX as an indicator of volatility as it is one of the most utilized and understood, there are a number of other calculations and tools available to determine market volatility. To learn more about stock market volatility, I recommend The Swing Traders Bible – Strategies to Profit from Market Volatility by Mathew McCall.
