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VOLATILITY


VIX for Victory

06/25/01 02:31:47 PM
by David Penn

Neither oscillator nor indicator, the CBOE's Market Volatility Index or VIX depicts the mood of the marketplace.

Security:   VIX
Position:   N/A

Unless you're an options trader, the Chicago Board Options Exchange's Market Volatility Index (VIX), may be a stranger to you. But rest assured that you don't have to be an options guru in order to use the VIX to help gauge the mood of the market. Used as a contrary indicator, the VIX can help point out when investor sentiment has reached the extremes of terror or complacency-- the sort of extremes that can signal intermediate and short-term tops and bottoms in the stock market.

A contrary indicator essentially means "when they zig, you zag." The logic behind the rationale (so to speak) of contrary indicators like the VIX is that when a consensus opinion becomes entrenched and treated almost like gospel, that is the time when the consensus opinion is most likely to be exposed as outdated. A familiar example of contrary indicators is the magazine cover. The thinking here is that by the time a particular issue or personality has become so popular that a magazine is ready to devote precious front-cover real estate to them, interest in the particular issue or personality has probably peaked and will begin to decline.

Figure 1: An excellent measure of market sentiment, the VIX suggests going long when its reading is high, and going short when its reading is low.
Graphic provided by: MetaStock.
 
Back to the VIX. The VIX specifically measures the "implied volatility" from eight call options and eight put options on the S&P 100 Index. Implied volatility, without getting too detailed, refers to the expected volatility in a stock's return when a variety of factors--such as the option price, maturity date, exercise price, and riskless rate of return--are considered in an option pricing model. In any event, the VIX itself is a weighted average of that measurement of implied volatility.

Generally speaking, when the VIX is high, it tends to signify that investors and traders anticipate a great deal of volatility in the market. Conversely, a low VIX suggests that investors and traders are expecting a relatively tame market, with few upside or downside surprises. In terms of stock trading, high VIX readings tend also to correlate with market bottoms, while low VIX readings are associated with market tops. A high VIX reading might be anything above 30. A low VIX reading might be anything below 20.

I've added a VIX chart for the period from August 2000, when the S&P 500 was trading near its all-time high, to the present, with the S&P trading at 22% off its high. Overlaid against the VIX is a plot of the S&P 500 (note that the VIX is based on the S&P 100). Both lines are plotted on a weekly basis to make the comparisons easier to see. In particular, note the August/September 2000 high in the S&P 500, and how it correlates with a significant low in the VIX. In fact, it is the only time the VIX fell below 20 in the time period examined. Conversely, note how during the S&P 500 lows of March 2001, the VIX was reaching extreme levels of as much as 37.

While not necessarily a fail-safe system, the VIX has historically done an excellent job of anticipating some of the signficant tops and bottoms in the market. More than anything else, the VIX is an excellent index of market sentiment, of terror and complacency, and is a worthwhile tool for any technically-oriented analyst studying the market vicissitudes of fear and greed.



David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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Date: 06/26/01Rank: 5Comment: 
Date: 06/27/01Rank: 5Comment: 
Date: 07/02/01Rank: 5Comment: Dear Sir or Madam, I am a Tradestation 2000i user and I receive my data from esignal. I receive real time data on the CME and CBOT. What do I need to do in order to plot the VIX? Thanks, Rob Rardon r.rardon@verizon.net
Date: 07/10/01Rank: 4Comment: 
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