How to Read the VIX
By Tony Saliba
Special to RealMoney.com
03/13/2002 11:50 AM EST
URL: thestreet.com
Since I continue to receive boatloads of mail on the subject, let me revisit the CBOE's Volatility Index, or VIX, and how it can be used for timing the market(s). Since the VIX is more or less a measurement of the at-the-money implied volatility of S&P 100 (OEX) options, we need to examine some of the characteristics of volatility first.
Volatility is mean reverting. This means that no matter how far volatility may stray above or below its long-term mean in response to short-term events (such as a terrorist attack sending volatility higher, or a slow holiday week sending volatility lower), it will eventually revert to its long-term mean.
Volatility is also auto-correlated. This means that the volatility of any given period is likely to correlate with the volatility of the previous period of the same duration. Therefore, low volatility today would indicate a good chance of low volatility tomorrow and so forth, until something causes the volatility regime to change.
Finally, volatility is dynamic, not static! Volatility responds to changes in the market just as stock prices do, based on movement and on supply and demand. The recent avalanche of convertibles (in lieu of IPOs) into the market has had a depressing effect on volatility, even though current events suggest that volatility should be higher. Therefore, arbitrary measurements of "richness" or "cheapness" cannot be used when pricing volatility.
If we examine an overlay chart of the cash value of the S&P 500 vs. the VIX, we can see that the VIX traded in a range of about 10 to 15 during the early '90s, then moved up to an approximate range of 20 to 30 as the great bubble rose and fell. I am sure you can pick out a few "bumps" along the way such as the Asian crisis of 1997, the Long Term Capital Management debacle of 1998 and, of course, the terrorist attacks of Sept. 11.
A Tale of Two Indices
S&P 500 cash value (red, left scale) versus the VIX (black, right scale)
We can see that if static levels had been used to evaluate the VIX during this time period, you would have had your head taken off several times over. (For example, if the spike upward in the VIX in early 1996 had been interpreted as a sell signal -- ouch!)
Because of its auto-correlation tendencies, it is important to look at levels in the VIX and other volatility indices in terms of their recent movement. Most traders using the VIX for predicting short-term turns in the market will use some sort of moving average as a "benchmark" value, and look for significant deviations away from that benchmark for signs of change in market psychology, thus triggering a trading signal. With this in mind, traders seeking to use the volatility indices should construct a benchmark that reflects their individual investment time horizon.
Of course, with volatility, "size" isn't everything, there is also "shape" or skew to consider, but that's a discussion for another day.
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Proprietary Numbers
Overall, call sellers outnumbered call buyers by a 3:2 ratio, and put sellers led buyers at 2:1. Nasdaq 100 Unit Trust (QQQ:AMEX - news - commentary) call buyers and sellers were even at 1:1. Microsoft (MSFT:Nasdaq - news - commentary) call sellers were out in force as well, leading buyers 3:2.
IBM (IBM:NYSE - news - commentary) call sellers outnumbered buyers 2:1. Amgen (AMGN:Nasdaq - news - commentary) call buyers led sellers 4:1. Intel (INTC:Nasdaq - news - commentary) put buyers now lead sellers 3:1. QQQ put sellers made their presence felt, leading buyers 3:1.
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Anthony J. Saliba has been a pioneer and active participant in the Chicago derivatives markets for more than 20 years, holding exchange memberships on the Chicago Board Options Exchange (where he was a board member from 1987 to1990), the Chicago Board of Trade, and the Chicago Mercantile Exchange. He is a founder and partner in STC L.L.C., a firm that provides price improvement and liquidity enhancement for options customers; International Trading Institute, Ltd., an internationally known derivatives training institution; HEAT Enterprises, (Hybrid Execution And Trading), an electronic show system that solicits customer order flow and routes contra orders, and First Traders Analytical Solutions, LLC, the solution provider for options front and middle office trading, pricing and risk-management systems. He also operates SalibaOptions.com. At time of publication, Saliba and/or his company held positions in the QQQ, IBM, Amgen, Intel and Microsoft, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Saliba cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to Tony |
