UnderCover
26-04-2005, Tue 3:09 PM
ÇáÊÍáíá ÌíÏ ááãÍáá ÇáÝäí Greg Capra ãä ãæÞÚ ÈÑíÓÊíä æÃÍÈÈÊ äÞáå áßã :
Much attention has been focused on the current increase in volatility that has developed over the last couple of weeks and I suspect it isn’t going to go away soon. The index that measures anticipated future volatility, as you might imagine, is called The Volatility Index (also know as “The VIX”). That makes perfect sense (unlike most things when it comes to the stock market). Lately, the VIX has been rising—as it should.
As I’m sure you have observed, markets tend to fall much faster than they rise. And the Volatility Index rises much faster at those times, as well. This occurs because fear is a more powerful emotion than greed and markets move faster to the downside. For that reason, the index is sometimes referred to as the Fear Index, as well.
To illustrate this, consider the experience between the following two situations. Have you ever been in a stock that rises slowly, falls back, and then rises again? If so, what were your thoughts and feelings at the time? Were they of complete confidence and certainty that the stock would move higher? Or were of a “quiet hope” (uncertainty) that the stock would hold that pullback and rise? For most, it was probably a feeling of relief as the latter scenario occurred. This is where the adage “climbing a wall of worry” comes from.
These plodding advances, which are self-correcting in nature, are of lower and declining volatility as the market advances. Now, what about being in the opposite situation of a stock falling like a bag of rocks from a roof top? Were you “certain” about what was happening then? I bet you were! And I bet you were willing to take decisive action, as well. Extreme moves bring about extreme emotion and irrational actions which is reflected in the Volatility Index. Although those actions are irrational, they are decisive but often wrong at extremes. Ever sell at the low? If not, you’re either very lucky or not telling the truth.
The most emotional traders are the ones who are using the most leverage and one of the most leveraged instruments to trade are index options. This is what makes the Volatility Index a useful tool. It is based on the pricing of index options. There are several Volatility indices and for this discussion I will use the index with the symbol $VIX.
Now, fears being stronger than greed for the reasons previously mentioned, traders are willing to pay higher premiums for options to hedge longs and/or attempt to profit during times of a falling market. Since option traders are typically wrong at extremes and willing to pay extremely overvalued option prices, the VIX is an excellent guide to changes in trader sentiment and turning points in the market.
A few years ago the Volatility Index had become a popular indicator. It was focused on by the media almost on a daily basis. Shortly after that focus began, like most things that become the focus of the majority, the VIX began to act in a way most had not seen before. In 2003, the VIX dropped below the levels which had been relatively constant for the prior seven years and then began a steady decline. It had not been below those levels prior to 1996 and those prior year’s low levels signaled a market decline was close at hand.
Typically, the Volatility Index rises as the market falls and it falls as the market rises. This being the case, the popular interpretation of the VIX in 2003 was that it had to rise and the market should fall. But the market had been through a crushing bear market and other market internals were suggesting the bear market had run its course.
What happened was, after a short rise in the market and fall in the Volatility Index to prior lows, the index keep falling and the market keep rising. This brings me to the point of this Chart of the Week: The VIX has begun to spike up from historic low levels and we should question what might be the potential meaning of this event.
In the past couple of Chart of the Week lessons, I have shown a few market internals that suggested a short-term bottom in the market. This is still case, but as I also mentioned, the price patterns in the indices are not suggesting the same from a long-term point of view. This places the two in conflict and most likely why the market indices are so erratic. In time, the two will come into alignment one way or the other, and we will have a much clearer long-term picture of the future market direction.
The question that I know will be focused on in the media is: Does this spike up in Volatility Index mean that the market is about to fall like that bag of rocks from a roof top? I don’t think so. But as I said at the beginning, I do believe volatility will be on the increase in the future. So, if I am right and the VIX has seen its lows and will rise, why shouldn’t the market drop since the market typically falls as the VIX rises?
Well, based on the current yield curve (the difference between long-and short-term yields), the odds of a bear market are unlikely. The spread between long-and short-term interest rates is one of the main legs of a bull market and it is still bullish. Of course, corrections always do happen and at times can be severe. But, what about that rising VIX and its correlation with a falling market? A look at the VIX of the past might point us to its and the market’s future movement
In the preceding chart, the VIX and the S&P 500 are shown from 1990 to the end of 1994. After the bear market of 1990, the S&P rose for the following years and the VIX trended lower as volatility contracted. For those who were in the market in 1994, they know that the sideways correction in the market really was an internal bear market. This is similar to what is occurring in the market today. If you have any doubt, just flip through some charts of some well known stocks. 1994 marked the lows in the VIX at extreme low levels and this seems to be the case now, as well. At that time, most thought the market was going to fall from that sideways correction. Especially since the VIX was beginning to move higher from a low level, as it is today. Let look at what happened after 1994 :
Much attention has been focused on the current increase in volatility that has developed over the last couple of weeks and I suspect it isn’t going to go away soon. The index that measures anticipated future volatility, as you might imagine, is called The Volatility Index (also know as “The VIX”). That makes perfect sense (unlike most things when it comes to the stock market). Lately, the VIX has been rising—as it should.
As I’m sure you have observed, markets tend to fall much faster than they rise. And the Volatility Index rises much faster at those times, as well. This occurs because fear is a more powerful emotion than greed and markets move faster to the downside. For that reason, the index is sometimes referred to as the Fear Index, as well.
To illustrate this, consider the experience between the following two situations. Have you ever been in a stock that rises slowly, falls back, and then rises again? If so, what were your thoughts and feelings at the time? Were they of complete confidence and certainty that the stock would move higher? Or were of a “quiet hope” (uncertainty) that the stock would hold that pullback and rise? For most, it was probably a feeling of relief as the latter scenario occurred. This is where the adage “climbing a wall of worry” comes from.
These plodding advances, which are self-correcting in nature, are of lower and declining volatility as the market advances. Now, what about being in the opposite situation of a stock falling like a bag of rocks from a roof top? Were you “certain” about what was happening then? I bet you were! And I bet you were willing to take decisive action, as well. Extreme moves bring about extreme emotion and irrational actions which is reflected in the Volatility Index. Although those actions are irrational, they are decisive but often wrong at extremes. Ever sell at the low? If not, you’re either very lucky or not telling the truth.
The most emotional traders are the ones who are using the most leverage and one of the most leveraged instruments to trade are index options. This is what makes the Volatility Index a useful tool. It is based on the pricing of index options. There are several Volatility indices and for this discussion I will use the index with the symbol $VIX.
Now, fears being stronger than greed for the reasons previously mentioned, traders are willing to pay higher premiums for options to hedge longs and/or attempt to profit during times of a falling market. Since option traders are typically wrong at extremes and willing to pay extremely overvalued option prices, the VIX is an excellent guide to changes in trader sentiment and turning points in the market.
A few years ago the Volatility Index had become a popular indicator. It was focused on by the media almost on a daily basis. Shortly after that focus began, like most things that become the focus of the majority, the VIX began to act in a way most had not seen before. In 2003, the VIX dropped below the levels which had been relatively constant for the prior seven years and then began a steady decline. It had not been below those levels prior to 1996 and those prior year’s low levels signaled a market decline was close at hand.
Typically, the Volatility Index rises as the market falls and it falls as the market rises. This being the case, the popular interpretation of the VIX in 2003 was that it had to rise and the market should fall. But the market had been through a crushing bear market and other market internals were suggesting the bear market had run its course.
What happened was, after a short rise in the market and fall in the Volatility Index to prior lows, the index keep falling and the market keep rising. This brings me to the point of this Chart of the Week: The VIX has begun to spike up from historic low levels and we should question what might be the potential meaning of this event.
In the past couple of Chart of the Week lessons, I have shown a few market internals that suggested a short-term bottom in the market. This is still case, but as I also mentioned, the price patterns in the indices are not suggesting the same from a long-term point of view. This places the two in conflict and most likely why the market indices are so erratic. In time, the two will come into alignment one way or the other, and we will have a much clearer long-term picture of the future market direction.
The question that I know will be focused on in the media is: Does this spike up in Volatility Index mean that the market is about to fall like that bag of rocks from a roof top? I don’t think so. But as I said at the beginning, I do believe volatility will be on the increase in the future. So, if I am right and the VIX has seen its lows and will rise, why shouldn’t the market drop since the market typically falls as the VIX rises?
Well, based on the current yield curve (the difference between long-and short-term yields), the odds of a bear market are unlikely. The spread between long-and short-term interest rates is one of the main legs of a bull market and it is still bullish. Of course, corrections always do happen and at times can be severe. But, what about that rising VIX and its correlation with a falling market? A look at the VIX of the past might point us to its and the market’s future movement
In the preceding chart, the VIX and the S&P 500 are shown from 1990 to the end of 1994. After the bear market of 1990, the S&P rose for the following years and the VIX trended lower as volatility contracted. For those who were in the market in 1994, they know that the sideways correction in the market really was an internal bear market. This is similar to what is occurring in the market today. If you have any doubt, just flip through some charts of some well known stocks. 1994 marked the lows in the VIX at extreme low levels and this seems to be the case now, as well. At that time, most thought the market was going to fall from that sideways correction. Especially since the VIX was beginning to move higher from a low level, as it is today. Let look at what happened after 1994 :