FYI | Mar 04 2010
By Greg Peel
When a stock market moves up and down, statistical measures are used to determine just how volatile that market has been on a relative basis. This is called “historical volatility”, and is very much a rear-view mirror statistic.
When stock market investors trade in options rather than stocks, they often do so because options offer protection against loss. Total possible losses are known at the outset. If a market is particularly volatile, or traders believe the market may soon become particularly volatile, traders may elect to buy call options instead of stock, for example, or buy put options as protection against stock positions held.
The price a trader will pay for an option is dependent on that view on volatility. The more volatile a trader believes the market could be, the higher price he or she will pay for the protection offered by options. Thus if volatility determines price, we can work backwards from a traded price to determine just what volatility level is implied by that price. This is called “implied volatility”.
The VIX volatility index in the US measures this implied volatility by starting with the prices paid for call and put options each day over the Chicago S&P 500 index futures contract and working backwards. A higher level on the VIX index means traders are worried and are seeking protection, and a lower level means they have little concern. Given stock markets tend to “rise by the stairs and fall by the elevator”, it is logical that traders have a much greater fear of actually losing money rather than missing out on making it. Thus a high level VIX reading tends to suggest traders are fearful of a big fall.
The following five-year chart of the VIX speaks clearly to the ebb and flow of market fear. From 2004 through mid-2007 Wall Street was enjoying a solid bull run and it seemed nothing would ever stop it. Demand for option protection was thus low, represented by the years the VIX index spent under the 20 mark. But in mid-2007 Wall Street was suddenly hit by the subprime crisis.
For the next year or so the VIX fluctuated in a range between the more relaxed 20 and the more worried 30s. In the history of the index, it had hit 40 a couple of times but never pushed any higher. Then when Lehman went down in 2008, the VIX shot to the unprecedented 80 level (and actually up to 90 intraday). There followed a long, slow decline back to the more relaxed 20 level as the market gradually came to accept the market bounce of 2009.
If we now look at a six-month chart we see the VIX has often approached or temporarily breached 20 in that period but not for very long. Spikes of fear usually follow.
If we now compare the VIX on a relative movement basis to the actual S&P 500 index over six months an obvious pattern emerges.
When fear spikes, stock prices fall. Or is that when stock prices fall, fear spikes? The chart shows little in the way of lead or lag time. Certainly if the S&P 500 suddenly takes a bath, traders rush into option protection. But there are other traders who work off a more contrarian stance, such that if I've made some good profits in the rally and the market is looking a bit overbought, I might just buy some put option insurance to lock in my winnings.
Over the past few years, the VIX has become a rather popular contrarian indicator. Now that the comfortable bull market days of pre-2007 are behind us, and GFC-based uncertainty still lingers, it seems every time the VIX approaches or drops below 20 something bad happens. You could say that the market had become too complacent.
On the flipside, it used to be that a VIX level approaching 40 meant the market was overly panicked and had oversold, thus offering a good contrarian buy signal. But then Lehman changed the averages dramatically.
But as the six-month chart above shows, the VIX has not liked spending much time near or below 20 lately. Something always happens when the market becomes too complacent.
The VIX closed last night at 18.83 following a couple of days of benign movements on Wall Street. The Dow average has reached back to its 2010, pre-Greece starting point a couple of times this week but has not managed to push through. If it does push through, then maybe we could be satisfied that another leg up is underway and the VIX is right to be under 20. But if we look at the comparative graph, legs up in the market tend to occur when the VIX is falling back from its highs, not when it has been sitting around at its lows.
Suffice to say that with the VIX now at 18, there are traders out there concerned another bombshell is about to be dropped that will send stocks southward again. Are they justified in this concern? Well that's how contrarian indicators work. Some people also follow the stars, but above we have some fairly robust data. It just happens too often, that's all.
