The VIX and Other Market Indicators
In This Chapter
- How volatile is the market
- Volatility and volume indicators
- Measuring the market’s mood
- How the market is moving
Financial markets are driven by information. Traders gather information about the market by looking at different market statistics to give them some insight. Even those who are not options traders often use the options market as a way to evaluate the overall financial markets. Options traders give people a window into what speculators see and what risks concern hedgers on any given day.
In the options market, strategies of countless market participants come together to create an aggregate view of the market. The signals given off by the options exchanges help options traders and other investors evaluate the mood of the market, its volatility, and other expectations about the future.
Remember vega, from Chapter 4 on the Greeks? Vega is the measure of implied volatility in an option. The greater the vega, the more valuable the option.
You might be familiar with such indexes as the Dow Jones Industrial Average and the Standard & Poor’s 500 Index. These are indicators of how the stock market is performing for a given time period. These indices give market observers a lot of information about the underlying market. For example, in the derivatives market, there are options on the index and on the stocks in it. Using that information, traders can calculate an implied volatility for the entire market. This calculation offers observers even more information.
Just as options derive their value from the value of an underlying asset, they derive their volatility from them, too. When translated to the level of the market as a whole, an understanding of volatility can help traders of all types see how the market’s behavior affects their positions.
Working with Volatility, Implied and Otherwise
To refresh your memory, volatility is a measure of how much prices vary over time. For example, you can have an average return of 10 percent with returns of 10 percent, 9 percent, and 11 percent over 3 years; or you can have an average return of 10 percent with returns of 30 percent, –10 percent, and 10 percent. The second series has a lot more variability than the first, so we would say that it is more volatile.
Remember that when valuing an option, the component that is not related to underlying value or time value is known as implied volatility, or vega. It’s a key reason for trading in options, whether the objective is to hedge or to speculate.
Underlying assets become more volatile as traders become more uncertain of what the value should be. This could happen because of a lack of information or because the underlying asset operates in an environment where the range of outcomes is really wide. For example, the size of the wheat crop is affected by the weather. The price of wheat is affected by the size of the crop. If the weather becomes more volatile, then so will the price of wheat.
People like steady and predictable performance, even though it is very rare. One reason people use options is to insure against volatility in the price of the underlying asset. The greater the volatility in the underlying, the more important the insurance function is.
In the financial markets, a bull market is one that is going up, so bulls are those who believe the market’s next move is up. A bear market is one that is going down, and bears believe the market’s next direction is downward. The options market offers many clues as to whether the overall direction is bullish or bearish.
Market Maxim
Anyone who can predict the future with certainty is retired and living on a beach in Maui. Everyone else is taking a risk.
The market isn’t human, although sometimes it seems like that to traders. The market has no emotion. The computers that direct a lot of the trades aren’t human, either, although they were programmed by human beings. They, too, have no emotion, but they read a lot of indicators about what’s happening in the markets.
Humans are emotional creatures who are a mess of nerves, feelings and ideas. And as human beings trade in the financial markets, at least some of these emotions play out in price and volume activity. The introduction of electronic trading hasn’t eliminated this, either. If anything, electronic trading magnifies the trends created by humans rather than tamping them down.
Sentiment indicators give you information about the broader market. Sentiment indicators fall into three categories:
- Leading Leading indicators show where the market will be moving.
- Lagging Lagging indicators show what happened and may confirm trends or indicate changes.
- Contrary Contrary indicators mean the opposite of what it seems. A positive signal from a contrary indicator means that the market may be expected to go down.
However, none of these indicators should be confused with clairvoyance. Sentiment indicators can be misread, and they can change. Strange and unexpected events can take place to change the mood of the market faster than the blink of an eye.
Definition
Sentiment indicators are metrics used to help options traders and other market observers discern whether prices will be going up or going down.
Put-Call Ratio
Want to know how people feel about a particular stock? Then check out the put-call ratio. The ratio is just that: the number of put options written divided by the number of call options written. The higher the put-call ratio, the more bearish the sentiment.
After all, if people are negative on a stock, they will want to buy put options in order to see if they can make a profit on the decline. If they think the stock is going up, they will buy call options. Of course, some of the buyers and sellers are acting without information, while other buyers and sellers are market makers and hedgers. There will always be both puts and calls outstanding on any underlying asset. A big change in the ratio, though, could signal a change in sentiment signaling an upcoming price move.
Traders tend to look at changes in the ratio rather than its absolute level. They also look for information explaining why the ratio is changing. A change that is driven by institutional investors who are hedging is viewed as more important than a change driven by retail customer volume. This difference is because retail speculators tend to be overly emotional in their trading.
Put-call ratios can be calculated different ways, depending on what’s being measured. The put-call ratio for one particular individual underlying asset is a way to measure sentiment for that asset, which may have nothing to do with sentiment for the broader market. A look at the put-call ratio for the entire market, or for a section of it, provides information about how bullish or bearish sentiment is for a broader market. Some traders look at the put-call ratio for index options to get a quick read on the overall market. You may see this metric used many ways to gauge sentiment.
These measures offer different perspectives on what might be happening in the market, and traders use a combination of them to gauge the current market direction.
Each day, the stock exchanges publish put-call ratios for the exchange as a whole, as well as put-call ratios for different types of options.
The following tables show really broad ranges of sentiment associated with different put-call ratios. Some traders use different ranges, depending on what they are trading and what market conditions are at any given time.
Put-Call Ratios for Index Options
If the Ratio Is … |
It Is Considered … |
1.50 or higher |
Bearish |
0.75 to 1.50 |
Neutral |
0.75 or lower |
Bullish |
Put-Call Ratios for Single-Stock Equity Options
If the Ratio Is … |
It Is Considered … |
0.75 or higher |
Bearish |
0.40 to 0.75 |
Neutral |
0.40 or lower |
Bullish |
There’s a wrinkle, though—there is always a wrinkle. Some people take a contrarian approach to the market, which means they assume the conventional wisdom is wrong. Hence, they will reverse the measures, buying when put-call ratios are really high and selling when they are low.
In addition to the general put-call ratio, some exchanges and research services have developed modified numbers designed to show clear bullish or bearish signals.
Put and Call Volume Indicators
The ratio of puts to calls provides one measure of sentiment. Changes in the level of trading volume in puts and calls offer another measure. As trading volume increases, traders begin to feel stronger about the likelihood of a change in market direction.
Some people buy puts as insurance, but others buy them because they are speculating on a price decline. Either way, the more put buyers out there, the more people are expecting the market for the underlying asset to go down.
Put indicators tend to be taken more seriously than call indicators because most financial markets have an upward bias. People would not invest in the underlying asset if they expected it to go down!
Open interest itself is not a sentiment measure because every long position is matched by a short position. It is the change in open interest that matters. (Have you forgotten these terms? They are covered in Chapter 2.)
Volume and open interest numbers are published daily by the exchanges.
Did You Know?
Different indexes and indicators are parts of big businesses. Publishers such as Dow Jones, and exchanges such as the Chicago Board Options Exchange give the basic information away for free as a way to promote their other services. Analysts who want more detailed information about how the prices change must pay for it. Detailed information is often included in a brokerage account’s services.
For all the math that goes into determining a fair valuation for an option, the basic determinant of price for an option is that same for anything else: supply and demand. If people want to buy (or sell) more of a given option, then the price will go up (or down) accordingly.
Hence, options traders look for trends in prices to see if there are changes in demand that might indicate future direction. Prices are tracked with price charts, and they are often analyzed using technical analysis (see Chapter 14 for more information). Technical analysis of prices is a way to see how market psychology affects the price of different underlying assets, as well as the options on them.
The options exchanges publish indices of put premiums and call premiums so people can see how they have changed over time. An increase in the put premium index tends to be a bearish signal, and an increase in the call premium index tends to be bullish.
Confidence Index
Many years ago, Barron’s, the weekly business newspaper, started publishing what it calls its confidence index. The confidence index is found by dividing the yield on high-quality bonds by the yield on intermediate-quality bonds. The idea is that the greater the return people want for intermediate-quality bonds, the more concerned they are about the economy. The greater the ratio, the more confidence held by investors.
The options-market version for the confidence index is based on the spread between the call premium index and the put premium index. This works because, if put-call parity holds, the primary difference between the two should be carrying costs (that is, interest and commissions). Carrying costs are highly sensitive to interest rates.
Here’s how you calculate that: take the difference between the put premium index and the call premium index and multiply by two. The result is an annualized spread between the two indices. The higher that spread is, the better the signal for the underlying asset in question—at least until the point of overconfidence. That’s that wrinkle in using sentiment indicators I discussed earlier in the chapter.
Implied Volatility
Implied volatility, also known as vega, is one of the key factors in option valuation. The more volatile an underlying asset is, the more likely an option on it is to end up in the money. Also, the more volatile the underlying asset, the more value it has to both hedgers and speculators.
And what causes volatility to increase? In almost all cases, uncertainty.
In fact, the Volatility Index (see the next section) and related volatility index options are followed for this very reason. They are looking at the implied volatility of the market as a whole.
Traders in single-stock options don’t need a specialized index because they can track the implied volatility in their options class to see what the expectations are for that company.
Market Maxim
The four most dangerous words in the English language are: this time is different. Markets move in cycles, and human beings tend to respond in predictable ways. Yes, sometimes there are significant new economic factors. However, in most cases, the market is the same old, same old. If people lost money the last time this cycle came around, they probably will lose money this time, too. Learn from history.
The VIX
VIX is short for Volatility Index, a measure introduced by the Chicago Board Options Exchange in 1993 as a way to communicate with the world about implied volatility. The index is calculated on the volatility of options on the Standard & Poor’s 500 stock index. The VIX is often thought of as the fear index, and it is followed by many market commenters and strategists for clues about the direction financial markets might be moving.
A high VIX indicates that investors perceive a lot of volatility, while a low VIX shows a lot of market confidence—maybe even too much confidence.
Did You Know?
The VIX and other market indicators are used for both straightforward readings and contrarian reads. A rising VIX means that uncertainty in the market is increasing. However, at some point, the uncertainty becomes so high that traders assume people are overly fearful and the markets will actually improve. Thus, a rising VIX is negative, but a very high VIX is actually positive. Thus, a high VIX is thought of as contrarian. One reason for this is that a lot of traders are not very sophisticated. Often, speculators are not as informed about the market as they could be. This means that they often jump in just as a trend noticed by professionals is ending.
Calculating the VIX
The VIX is calculated based on the CBOE’s SPX contract, which is an option on the value of the S&P 500 Index. The S&P 500 Index, in turn, is a measure of the stock market based on the market values of 500 of the largest companies in the United States.
The SPX options are traded to speculate on, or hedge, the global financial markets. Although the S&P 500 is an index of American companies, it is heavily weighted toward multinational companies. The size of the U.S. economy relative to the rest of the world makes the S&P 500 the best world proxy we have now. It’s not perfect, but no sentiment indicator is.
The math that goes into the VIX calculation is complicated, but it pulls out the expected 30-day volatility of the S&P 500 Index from the other factors such as underlying value and time to expiration. These are the same factors that go into the valuation of the index options. It uses both standard and weekly options to back out the volatility expected in the next 30 days.
In other words, the VIX is an index based on the volatility of options that are based on the value of the S&P 500. Yes, I know, that’s a complicated definition. It takes a few different steps to isolate the volatility of the market as a whole. The calculation method itself isn’t terribly important to a beginner trader. What is important is how it is used to measure market sentiment.
Using the VIX
VIX options can be used to speculate on the future direction of the market and to hedge changes in market direction. For example, equity investors might want to reduce the amount of market risk in their portfolios. They can do this by writing puts on the VIX. This would let them sell the market volatility to someone else. By offsetting the effect of volatility on the overall portfolio, they reduce risk, and that’s valuable.
The basic idea of the VIX as a sentiment indicator is this: If people expect the market to be volatile, then they will be more likely to want insurance and thus to buy VIX options. This will push up the price of the VIX, even if the underlying market remains flat. Hence, the VIX is used to isolate expectations about future market volatility.
The VIX now trades almost around the clock so that speculators and hedgers alike can consider events in Asia and Europe as well as in North America. This improves its significance as an overall market indicator despite being based on the S&P 500. The CBOE has both options and futures contracts on the VIX, including options with weekly expiration.
Because the VIX has been around since 1993, it has a long history of data for researchers to analyze. The track record of the VIX for predicting problems in the stock market is mixed. Volatility is an important component of valuation, for the market as a whole and for individual underlying assets. However, a change in the VIX might not show a change in market volatility, and a change in market volatility might not indicate a change in market valuation. The VIX is one signal among many, but one that has proven popular as a way to trade on volatility.
The VIX has proven so popular that the CBOE has issued options on other forms of volatility, including energy, emerging markets, and a handful of very large stocks such as Apple and Goldman Sachs. Other exchanges have introduced versions for other markets, such as Hong Kong.
Some brokerage firms and research services have different volatility measures that are based on the VIX or VIX-like measures, with adjustments to improve the performance of their chosen measure as a leading indicator. (The index market is really competitive, believe it or not.) The idea behind these measures is huge, but there is room for improvement on the execution.
Market Maxim
John Maynard Keynes once noted, the market can remain irrational longer than you can remain solvent. Sometimes, the market makes no sense at all. Someone will make money when the market moves from irrationality to rationality. However, a lot of people will lose money. This is especially true when the broker asks you for money to cover your losing position.
Using Indicators
Market indicators are goofy. They exist because circular trading activities generate indicators that other traders use to plan their trading activities. The exchanges then develop derivatives products based on these indicators that, when traded, generate more indicators used by traders to plan more trading activities.
Options traders use market indicators to figure out where the market is going, how strong that movement is likely to be, and what strategies they want to use to hedge or speculate on those changes. Some of this information is good, and some is noise. It may take some time to figure out which indicators work for you. However, if you know a bit about how they are used, then you can better monitor and evaluate them for your trading.
Don’t let the terms bullish, neutral, and bearish confuse you: there are profit opportunities in every type of market. (Of course, there are ways to lose money in every type of market, too, which is why you need to prepare before placing an order.)
Bullish Strategies
If the indicators point to a strong market, then speculators will want to take on more risk in order to profit from it. The simplest, and most bullish strategy, is to buy a call, or to place an order with the broker for a call option.
Bullish strategies look to maximize the upside return. Pushing off risk is less of a concern, but traders should be aware that nothing goes up in price forever.
Neutral Strategies
For all the excitements of bull and bear markets, they aren’t as common as you might think. The financial markets have long periods of being sideways, which is trader lingo for a neutral market. Prices move up a little bit and down a little bit, in no discernable direction, for periods ranging from minutes to months.
During these periods of sluggish activity, options traders tend to focus on income strategies. These neutral strategies include writing puts and calls in order to collect the premium as well as straddles and spreads (covered in Chapters 8, 9, and 10).
Bearish Strategies
Bearish strategies fall more along the line of hedging than speculation. Bearish strategies are designed to protect asset values. Nevertheless, options markets give traders quite a few ways to make money on market weakness, including the most bearish strategy, buying calls.
Some people think it’s distasteful to make money with a play on prices going down. However, if traders didn’t speculate on the downside, overall economic losses from declines could be far greater than they would be otherwise. Options markets have an insurance component; people buy options as much to hedge a position as to speculate on it. Furthermore, speculation on both sides of the market ensures that markets perform their important price discovery functions, helping everyone find the price where both buyers and sellers are satisfied.
The Least You Need to Know
- Successful trading starts with evaluating the mood of the market.
- The options markets have many indicators that traders can use to gauge market sentiment.
- The VIX and other volatility indexes are ways to trade directly on market sentiment.
- Bulls expect market prices to increase, and bears look for them to fall. Both can make money.