Any thoughts on this from the cyclepro?
Current Commentary -- Where Are We Now?
geocities.com
(Wednesday 2/28/2001 PM): Some of the recent stock market chat room discussions have been concerning a trading range for volatility indexes. The OEX volatility index is the VIX. Simply, the VIX is a measure of implied volatility as measured through option model back-calculation from the at-the-money call and put OEX option prices. The QQV is the volatility index for the QQQ options. There are other volatility indexes too.
Whether the underlying index is rallying or falling, the volatility index basically measures how eager a trader is to buy an option in the prevailing direction of the percieved trend. The more anxious they are, the more they are willing to pay. Instead of submitting a limit order for the option, impatient traders will often times opt for market orders. The quicker the price of the option rises, the higher the volatilty index rises. More complacency results in lower relative prices and volatility.
The recent discussion has been that these volatility indexes are good contrarian indicators of when the index is about reverse direction. During times of moderately sideways or gently sloping trends, this is a very true statement. However, caution is recommended during times when the index is on the verge of a major move.
To illustrate this situation, the following chart shows a similar scenario in 1987. On Friday, 16 October 1987, the VIX spiked higher in reaction to a sharp sell-off in the major stock market indexes. This chart shows that the VIX, which had been trading in the low 20's for several months, suddenly spiked to an intra-day high of 39. Click the chart to see what happened when trading resumed the following Monday, 19 October 1987.
Click chart to view next sequence.
Once a major shock has occured and the volatility indexes have spiked, it normally takes a long time before complete complacency returns. In 1988, it was 5-6 months later that the VIX touched below 30.
What this means is, let's say the market has a significant sell-off, but you are still quite bullish. So you want to buy call options when you think the market is ready to turn back up. Spike downs are often times immediately followed by spike up's, right? Unfortunately, buying a call option when the volatility is very high means that you will have to pay a higher-than-normal price for it -- as the market moves higher, the erosion of the volatility index may not fall as fast as the market is rising. Therefore, call buyers will discover that although the market may have approached or reached a previous higher-level, the market value of the call has barely appreciated compared to the spike-low price level.
For at least the past 1/2 dozen years or so, the VIX has always increased whenever the underlying index was experiencing a sell-off. The quicker the sell-off, the faster the VIX moved higher. This is a normal scenario during strong bull markets. It has been common belief that high VIX levels are reliable indications of market bottoms.
When a bull market ends and the bear market takes over, the VIX will go through a transformation. During the early stages of the bear market, the VIX will continue to function well as an overbought/oversold indicator. Slowly, as more investors turn bearish, previous "oversold" levels become even more oversold and overbought levels rarely reach as low as they used to. In this environment, more traders become eager to jump on the next down wave, so they begin selling earlier and earlier as the VIX approaches their "overbought" levels.
When a new trend has been established and novice traders begin to recognize it, they tend to jump aboard while the VIX is rising rapidly. Although novices do not monitor the VIX, their additional activity pushes the VIX to even higher levels.
Closer to the bottom of a bear market, the VIX will be completely transformed. Complacency will mean that a majority of traders expect even lower index levels. Thus, the VIX will actually be lower in sell-offs and rise during sharp rallies. What it boils down to, is the VIX increases when the majority of traders are surprised by a sharp move in a direction opposite of their expectations -- bear market volatility indicators are exactly opposite than during bull markets.
Last week the VIX reached an intra-day high of 37.72. Many traders believed this was an indication that a bottom had been reached. Hindsight has shown they were wrong. Today, most major indexes traded to lower-lows despite a VIX in the low 30's.
Please do not misinterpret my message... the VIX is an extremely valuable indicator, and it is likely that it always will be. However, the slow transformation that I have written about should be reviewed when you begin to notice that your old VIX expectations aren't working as well as they used to.
The current bull market began in 1982. The VIX indicator has only been around since 1986. We have never actually witnessed how the VIX reacts during a long-term bear market. This leaves my discussion of bear-market VIX in the realm of theoretical. In a couple of years, we can look back at this posting and we'll see if I was right.
I doubt that another 1987-like panic will ever occur. The DJIA now has circuit breakers that trigger automatic shutdown of all stock market, equity futures, and option trading. Instead, the sell-offs will be relentless and determined, but over a longer period of time rather then a one- or two-day event. But there is one tiny fact that you must be aware of if/when another sharp sell-off occurs... the circuit breakers are set up to be triggered only on the DJIA, no other index will trigger it. Therefore, it is entirely feasible that the DJIA might be down -5%, yet the S&P 500, Nasdaq, Value Line, Russell, or other indexes could all be down much, much more. Even Nasdaq down -20% would not solely trigger the circuit breakers.
Regards,
John M. |
