MASTERING THE MARKETS | VIX
VIX VIX
5 year % change vs. SPX Index (SPX) *
SPX
values below 20 generally correspond to less stressful, even complacent, times in the markets. There is an inverse relation between VIX and the stock markets. When one declines the other goes up and vice versa. Volatility is highly susceptible to the direction of movement. A downward spiral or extended decline leads to a greater demand for put options. This in turn drives up put prices as well as the implied volatility. Since puts are often used as a hedge against long positions, analysts see the VIX as a coincident indicator. When stocks move VIX moves though in different directions. Since VIX moves in an opposite direction to the stock market it is often seen as a trend verifying indicator. Traders use the volatility index to predict market reversals. The negative correlation of volatility to stock market returns is well documented and suggests a diversification benefit to including volatility in an investment portfolio. For instance, if a trader believes that
market volatility is going to increase he could make a profit on this position by buying VIX call options. According to the CBOE, one of the most valuable features of the VIX Index is the existence of more than 20 years of historical prices. This extensive data set provides investors with a useful perspective of how option prices have behaved in response to a variety of market conditions. Price history for the original
2012 2013 2014 * The S&P 500 Index (SPX) is a price index that does not include reinvested dividends. 2015
CBOE Volatility Index (VXO) based on OEX options is available from 1986 to the present. CBOE has created a similar historical record for the new VIX Index dating back to 1990 so that investors can compare the new VIX Index with VXO, which reflects information about the volatility “skew” or “smile.” By measuring investor fear levels
tick by tick, and day by day, the VIX, like many emotional gauges such as put/ call ratio and sentiment surveys, can be used as a contrary opinion tool in attempting to pinpoint market tops and bottoms on a medium-term basis, states Investopedia. There are two ways to use the VIX in this manner: The first is to look at the actual level of the VIX to determine its stock-market implications. Another approach involves looking at ratios comparing the current level to the long-term moving average of the VIX. This second method, known as detrending, helps to remove long- term trends in the VIX, providing a more stable reading in the form of an oscillator.
VIX does not meet the criteria of a
predictive indicator. At best, it happens to be a sentiment indicator which reacts to movements in the stock market. A sharp decline in stock market can cause exaggerated spikes in the VIX, reflecting the panic. Spikes in stock market lead to low levels of VIX. As in case of other sentiment indicators, the Volatility Index must be seen along with other indicators to better time the market.
47
-50% 0% 50% 100% 150%
2016 Jan
Did You know??
• VIX can play a key role in the in derivatives pricing, trading and risk control strategy
• Volatility is not immune
to the direction in which the market moves.
•
A surging stock market is perceived to be less risky while a bearish market holds greater risk. If the perceived risk is higher, py
the implied volatility is higher
higher.
February 2016 |
www.wealth-monitor.com
Source: Chicago Board Options Exchange (CBOE)
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