Understanding the Market Volatility Index

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Market Volatility Index (VIX and VXN)

First of all, our strategies exploits changes in volatility via identifying key areas where supply/demand has changed via WRB Analysis.

However, we don't use the VIX or VXN for such.

Instead, we use the VIX and VXN to help with position size management and to help with trade management.

Yet, we invite you to our new discussion forum at the below link to ask us questions about how to use the VIX and VXN for position size management or trade management.

http://www.thestrategylab.com/tsl/forum

With that said, the information below about the Market Volatility Index will give you a strong basic understanding about what it is.

What exactly is the Volatility indicator or index?

(today's charts and other resources at bottom of this education post)

The Chicago Board Options Exchange (CBOE) Market Volatility Index (VIX) indicates the level of anxiety or complacency of the market. It does this by measuring how much people are willing to pay to buy options on S&P 500 'futures' (SPX), typically 'put' options when are a bet that the market will decline.

Sophisticated investors buy S&P 500 futures 'put' options to protect their stock portfolios or even to speculate that the market may decline. If the market does decline, the value of the put options increases, compensating for the lose of value in the stocks.

You could buy put options for each stock in your portfolio, but that's more expensive and tedious. Options on the S&P 100 futures are more readily available and the market for them is more 'liquid', meaning they can be bought and sold more quickly, especially in large volumes.

There are a number of factors that go into the pricing of options. One of them is 'volatility'. It's simply the extent to which the price of something has changed over a year, measured as a percentage. An option on a more volatile stock or future will be more expensive. But options are just like any other asset and as really priced based on the law of supply and demand. If there is an excess of supply compared to demand, the price will drop. Conversely, if there is an excess of demand, the price rises. Since all the other parameters of the option price are predictable or measurable, the piece that relates to demand can be isolated. It's called the 'implied volatility'. Any excess or deficit of demand would suggest that people have a difference in expectation of the future price of the underlying asset. In other words, the future or 'expected volatility' will tend to be different from the 'historic volatility'.

The CBOE has a rather complex formula for averaging various options for the S&P 100 futures to get a hypothetical, normalized, 'ideal' option. The volatility component cant be isolated from the the price of this ideal option. That's VIX. Although both 'put' and 'call' options are included in the calculation, it is the 'put' options that lead to most of the excess demand that VIX measures.

VIX is a good surrogate for market sentiment. When everything is wonderful in the world, nobody wants to buy put insurance, so VIX falls. But when it looks like the sky is falling, everybody wants insurance in spades and VIX heads for the moon.

Values for VIX tend to be between 10 and 100. Even in the most idyllic of times, VIX may not get below 12 or 13.

VIX tends to move opposite the market. The market goes up and VIX goes down. The market goes down and VIX goes up.

VIX is viewed as a 'contrarian' indicator'. Higher values (when the market is way down), such as 40, can represent irrational fear and can indicate that the market may be getting ready to turn back up. Lower values (when the market is way up), such as 14, can represent complacency or 'irrational exuberance' and can indicate the the market is at risk of topping out and due for a fair amount of profit taking. There's no guarantee on any of this and VIX is not necessarily by itself a leading indicator of market action, but is certainly an interesting indicator to help you get a sense of where the market is.

10-15 - Excessive complacency

15-20 - Moderate complacency

20-25 - Low anxiety. Just about right.

25-30 - Moderately high anxiety

30-35 - High anxiety

35-40 - Very high anxiety

40+ - Panic

You can feel fairly comfortable if VIX is moving in a range between 18 and 27.

Note: The above numbers are those of the VIX...currently, we are getting the numbers for the VXN. Until then...the method for VXN is very similar to VIX, the difference being that below 60 would be considered bearish and above 90 would be considered bullish.

Also, many active traders use the VXN as a signal for a major market change when trading Nasdaq 100 Emini Future NQ or the big contract ND because many feel it's a better indicator than the VIX...especially when the VIX isn't correlating well with the Nasdaq 100.

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What happens when the VIX and the market produces conflicting signals?

Conflicting signals between VIX and the market can yield sentiment clues for the short term. Further, overly bullish sentiment or complacency is regarded as bearish by contrarians. On the other hand, overly bearish sentiment or panic is regarded as bullish.

Lets say the market declines sharply and VIX remains unchanged or decreases in value (towards complacency), it could indicate that the decline has further to go. Contrarians might take the view that there is still not enough bearishness or panic in the market to warrant a bottom.

Lets say the market advances sharply and VIX increases in value (towards panic), it could indicate that the advance has further to go. Contrarians might take the view that there is not enough bullishness or complacency to warrant a top.
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VIX can occasionally 'spike' or move up very rapidly as people receive a sudden shock. But frequently people over-react and VIX quickly settles back, at least somewhat.

During a true crisis, it's not uncommon for VIX to have a 'spasm' of spikes, each higher than the previous as anxiety increases with the severity of the crisis. Perceived severity that is.

Many people on Wall Street subscribe to the "If there's smoke, there's fire" philosophy and "head for the exits" at the first hint of trouble. Cooler heads tend to take advantages of those over-reactions and bring the anxiety level back down. But when real events do suggest that anxiety should be higher, VIX will rise again, this time to a higher level.

This cyclical process continues until the perceived anxiety matches the actual crisis. Many crises are resolved in short order, so VIX will spike up and then come back time. But the resolution of a crisis may take days or weeks or even months to resolve to the market's satisfaction.

Market observers sometimes refer to a spike in VIX as an indication of a 'capitulation'. When it looks like the sky is falling everybody who is likely to sell has done so. Or they bought S&P 100 futures 'put' options to protect themselves against a further decline.

But if all the sellers have sold, there's nobody left to sell. It's only selling that makes the market go down. And there're enough optimists to buy any dip. It's also called an 'exhaustion of selling'.

This is considered a sign of a 'market bottom'. But a market bottom may not be a final market bottom. That's why you see a spasm of VIX spikes and not just a single sharp spike.

It may just be a ledge on the way down even further. There will always be optimists that jump the gun before it's really time. For a true bottom and ultimate capitulation, there really needs to be some kind of good, soothing news that leads people to believe that yes, the worst really is past.

Traders may also use relative changes in the level of VIX as a 'signal' for buying or selling. If the VIX does not hit a very high or very low level, traders might simply note that it has moved more than 10% or 20% and use that to suggest that a rally or correction could soon run out of steam soon.

In other words, it's a way of sensing whether the market has moved too far (up or down) too fast to continue in that direction much longer, at least in the short run.

There are other simpler explanations of the Volatility Index at StockCharts.com

Recommended Books for the Informed Active Trader

Note: You need to know and understand how options affects your futures and stock trades...thus, stay informed or play the lottery...your decision.

- Trading Connors VIX Reversals - Connors on Advanced Trading Strategies

- Advanced Options Trading - Buying and Selling Volatility

- McMillan on Options - Market Volatility

- Option Volatility & Pricing - The New Option Secret

Sincerely,

M.A. Perry
http://www.thestrategylab.com

Phone: +1 708 572 4885
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