VIX Tricks
September 2, 2015
By Tyler Craig CMT |
When the VIX is at 16, the market is pricing in 1% daily moves. When it’s at 32, like now, the market is pricing in 2% daily moves. On the rare occasion when it rises to 48, it’s pricing in 3% daily moves, or insanity, in other words. Now you know why it rarely gets that high.
Gather ’round boys and girls: today I’m going to reach deep into my bag of tricks to unveil one of my favorites.
It’s handy in all sorts of market conditions, but particularly so when the crazy train comes to town. You know, like now. When the denizens of the Street are running around with their hair on fire. When random gaps greet you each morning and multi-percent moves become commonplace. This particular tactic provides context and proper expectations for volatility.
‘Tis a VIX trick.
I first introduced you to the VIX, formally known as the CBOE Volatility Index, in The Fear-O-Meter back in July. Go back and read it if you haven’t.
Also, why haven’t you read it? Good gosh man, I’m trying to educate you, but there’s a method to the madness. Order, chronology and such. So go read it and return.
I’ll be here when you get back.
The VIX is like a Swiss army knife, a multi-purpose tool with a gajillion uses. In July’s missive, I highlighted how the VIX is used as a contrarian indicator to identify when extreme fear is present. Today I’ll show you how the VIX level suggests how much the market should move on a daily basis.
And why is that handy?
Well, wouldn’t you like to know if the market is expected to move 0.5%, or 1%, or 2% per day? I suspect you would trade differently or at least adjust your expectations if 2% daily moves are the norm. In case you weren’t aware, 2% daily moves on an Index like the S&P 500 are kind of insane.
Enough with the preamble; on to the trick.
Volatility is expressed as a percentage and represents a one standard deviation annualized move. Yes, I know I went all math speak on you there, so allow me to unpack things a bit. First, volatility, hereafter referred to as vol because that’s what the cool kids call it, is expressed as a percentage. So when you see the VIX at 30, we say it’s at 30%.
Second, vol represents a one standard deviation move. If you reflect back to your days of statistics class you’ll recall, unless you dozed off, you slacker, a one standard deviation move should occur roughly 68% of the time. That’s about 2/3 for those of you who prefer the measuring cup method.
Basically, vol doesn’t predict the move we’ll see 100% of the time, but rather the price move we should see most of the time. It’s a one standard deviation move, ya dig?
Third, it’s an annualized move. Or, a move you should see over one year.
So, a VIX of 30 means the S&P 500 could rise or fall 30% over the next year. That’s the expected move given current option prices. Now, it’s not a guarantee; the range of up/down of 30% represents a one standard deviation move, so there’s approximately a 68% chance we remain within the range.
Here’s where the trick comes in.
No active trader is going to hold a position for one year. Knowing the expected move for that long, then, isn’t relevant. It would be much more helpful if we could determine the expected daily move for the market.
…and we can with the Rule of 16.
Just take the VIX, or any measure of implied volatility, and divide it by 16. That will give you the expected daily move for the market based on current option premiums. When the VIX is at 16, the market is pricing in 1% daily moves. When it’s at 32, like now, the market is pricing in 2% daily moves. On the rare occasion when it rises to 48, it’s pricing in 3% daily moves, or insanity, in other words. Now you know why it rarely gets that high.
And, you also know why in normal markets it spends its days sub-16. Because in normal markets the S&P 500 doesn’t move 1% a day. It moves less.
Class dismissed. |
