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Definitions:
Volatility:
Volatility is a measurement of change in price over a given period. It is
usually expressed as a percentage and computed as the annualized standard
deviation of the percentage change in daily price. Obviously, the higher the
level of volatility of a security, the higher the risk/reward of owning this
particular security.
Market
Volatility Indexes (VIX, VXN): They measure the volatility of the
markets. They are constructed by taking the weighted average of the implied
volatility of the OEX and NDX calls and puts respectively. The higher their
value, the higher the price speculators are willing to pay for put options
relatively to call options. Usually people are willing to pay more for something
that they perceive it is more likely to happen. The logic goes that, if the
majority of investors are expecting the market to move lower -thus they are
bidding put options higher relatively to calls- then the market will do the
opposite. In relative terms this is true, but it is not in absolute
terms!
How
We Decide The Best Way To Use An Indicator:
In
deciding how to use an indicator we need to answer three questions:
1. Relative Values or Absolute Values?
2. Leading Or Lagging ?
3. Are We In A Bull Or In A Bear Market?
1.
Relative Volatility Vs Absolute Volatility
It
is important for traders to understand that the market possesses
"dynamic" characteristics. In other words, it is constantly changing
and evolving, thus indicators in order to remain objective and accurate they
must change and evolve along with the market, in order to reflect its new and
ever evolving character. To illustrate my point, take a good look at the VIX and
VXN for the period between January 1995 and September 1997.
We
can see very clearly that the absolute value for the VIX kept rising,
while the OEX was experiencing an un-precedent advance! Notice that in
November of 95 a value of 15 represented a "bottom" while in
July of 96 a value of 15 represented a "top" Obviously if a
trader had marked "15" as the magic number to identify
"bottoms" he would have never seen that level again to this day!
The corresponding values of the Index to "bottoms" and
"tops" of the OEX kept rising, as the OEX kept rising, reflecting the
reality that the higher the value of a security the higher the volatility it
will possess. In other words, the OEX is expected to be a lot more volatile when
it stands at 500 than when it stands at 100. The same holds true for the NDX as
well. Take a look at the chart below.
Notice
how back in January of 1996 a value of "35" represented a
"bottom" while by today's standards such a value would represent a
top! So, I hope I made my point clear why it is useless to look at
"absolute values" What really counts is the values that are relative
to the times we are in! Now that we have determined that what matters is
relative values instead of absolute values, the next factor to consider is
whether the indicator is a "leading" or a "lagging" one.
2.
Leading Or Lagging ?
Why
is it important to determine the above? It is because leading indicators work the best in "trading markets" only in tandem with the
primary trend in place, not against it. In a market trending up, the best use is to help identify
oversold conditions for buying opportunities. In a market that is trending
down, leading indicators can help identify overbought situations for
selling opportunities. Many people lost money buying into NASDAQ during
the decline from September 2000 to April 2001, because they falsely used
leading indicators to identify "oversold" points! In a market that is
trending down you use these indicators to identify "overbought" points
to go short! Volatility Indexes are leading indicators,
thus we know that they work the best in tandem with the primary trend.
3.
Bull Market Or Bear Market?
If
we are using an indicator that works best in tandem with the primary trend, then
by determining whether we are in a Bull or Bear market, then we know what the
primary trend is, and thus we know whether we are going to use the indicator to
identify "oversold" conditions or "overbought" conditions. A
very important point is this: The trend is your friend, except at the end, when
it changes on you!! So what happens if at the end you got it wrong? Nothing if
you are using money management techniques in your trading. For example, if you
"step" into your positions in increments of 30%, and you set stop
losses at 10% above/below entry, then at the most you will lose 3%, no big deal.
and that is if you are totally inexperienced, and you can't tell that the trend
has changed, most experienced traders can tell.
So
now let's put it all together! To account for the three factors I mentioned
above, we need to employ a "derivative" measure. We accomplish that
easily -without the use of calculus- by using use the Volatility Indexes in
conjunction with Bollinger Bands. In reality, we are measuring the
"volatility" of the "volatility." If it is confusing,
just take a look at the charts below, and I will explain in detail!
Bollinger
Bands possess a very unique quality: almost 80% of the time, they correctly give
an accurate signal when the following phenomenon takes place: the subject first penetrates
the band, then it comes back into the channel and makes a secondary high or low inside
the channel! That is a signal that "volatility
exhaustion." So, let's apply this to where the markets are at the
present moment. As we can see the VIX just penetrated its upper band, that means
this is the start of the move not the end!
To have a "bottom" we need to see something similar to what we saw in
the previous occasions (see red boxes) We need to see the VIX coming
back into the channel and making a secondary high inside the upper band!
Unless you are a very experienced trader, this is not the time to go long.
This is the time to start taking profits in short positions -incrementally- and
be out of shorts by the time the VIX makes its secondary high inside the
channel. At that time you can start going long incrementally!
Of
course all the above hold true for NASDAQ and VXN.
Finally,
this chart also illustrates my point about relativity. Notice how the VXN had
its highest reading ever in April of 2000 when the NDX reached 3250. Since then
it has been making lower highs : below 90 in December of 2000, and right around
80 in April of 2001. SO, if you were expecting the VXN to go back to 90 in order
to identify a "bottom" you would not have been able to do so. The
VXN has been coming down, because NDX is expected to be less volatile when
it trades at 1500 than when it traded at 3250.
Conclusion:
In
using these indicators, do not be willing to jump into the market with both
feet, just because they reached an "extreme" value.
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