This
week’s stock market article may appeal to the nerdier
among us. But it need not be discounted out of hand by the novices.
As you’ll see in a moment, the interpretation of this interesting
chart indicator is very simple yet important.
The Volatility Index or “VIX” is an indicator that
measures the expectations of near-term volatility as shown by the
S&P 500 index option premiums. The VIX was introduced in 1993
and is now considered by many to be an excellent indicator of both
market volatility and investor sentiment.
The VIX can be thought of as a "Fear gauge" as
it reacts to market volatility which is often spurred by fears,
uncertainty
and turmoil.
The fundamental
use of VIX is to consider expected market volatility over the
coming 30 calendar days. As of September
2003, the VIX
is calculated with a new formula that considers the average of
weighted prices of both out-of-the-money calls and puts, and Standard
and Poor’s 500 options. Formerly, the VIX was calculated
using the Black Scholes model of option pricing and the OEX.
The Volatility
Index (VIX) is a measure of implied or expected future volatility
rather than historical or statistical volatility.
As the VIX rises, a greater sense of investor fear or uncertainty
is implied. When the VIX is low, a relative state of investor complacency
is indicated. So, periods of market turmoil will show an increased
VIX; primarily because the demand for OEX put options as hedges
is increased.
When comparing
a VIX chart to an S&P Index chart, an inverse
relationship of the two traces will be noted. Because of this,
the VIX can be employed as a contrarian indicator in a similar
fashion
to oscillating indicators such as stochastics or Williams %R. You’ll
see what I mean in the chart below.
What we are
doing here is looking at the options market as an indicator as
to what the stock market is likely
to do. With the
increase in use of options, over the past decade in particular,
we find that the stock and options markets are becoming increasingly
intertwined.
When a divergence
between the VIX and the direction of the S&P 500 index is seen, we expect a change in the S&P
direction to soon arrive. This counterbalancing relationship is
not particularly helpful in short-term trading but can offer excellent
insight in overall market bias, whether Bullish or Bearish. |
