13 Feb Analytics – Volatility: the Secret to the Stock Market
Ever wondered why the markets did this, or reacted in that way? Have you been looking for some way to gain insight into stock market behaviour?
Analytics explains what has happened, and why prices are where they are right now. There are methods that are deemed ‘predictive’, but as with anything that is looking forward, there are always numerous influences that will make or break that predetermined expectation that you formed.
Sentimental behaviour of market participants is an area that many traders/investors just don’t understand. Fundamental analysis explains the strength of a company. Economics explains the strength of the broader investment environment. But stock prices can still rise or fall irrespective of the data provided from both Fundamental and Economic analysis.
I’m going to provide a quick review of market Volatility. This is one of the key tools professional analysts use to evaluate market sentiment. Not only on the broader market, but in individual stocks as well.
If you’re looking for an edge to your Analysis approach, this is it!
“No-one can predict the markets! If you could, everyone would be doing the same thing. The markets are a random accumulation of events. Most can be analysed, reviewed and defined as having a positive or negative influence on prices. But you never know how Investor Sentiment is going to react.”
So what is Volatility?
The textbook definition of Volatility is the “liability to change rapidly and unpredictably, especially for the worse.” Source: Google Dictionary
In the reality of the markets, Volatility is associated with Risk. Simply put; the higher the volatility, the higher the Risk.
But with Risk comes Return. When you have more opportunity for a strong return, you have higher Risk. So it is like a double-edged sword.
Volatility can also be thought of as Uncertainty. How much uncertainty there is towards prices continuing to rise or fall. For example; as prices decline, the degree of uncertainty towards where the bottom of the movement will be, increases Volatility. That is, Uncertainty.
For me, reading Volatility in the markets provides me with insight into Investor Sentiment. That factor of mass people behaviour, like sheep following sheep. The broad panic or Fear Of Missing Out (FOMO) that drives people to buy or sell irrespective of what is going on Fundamentally or Economically.
We’ve recently experienced this with the price of Bitcoin.
Irrespective of what your views are on this investment (I use the word investment loosely), market sentiment drove the price of Bitcoin from around $800 in early 2017, to $17,900 in December – a rise of 2,137%! Source: https://en.wikipedia.org/wiki/History_of_bitcoin
[Note; various prices are quoted from different sources. This example has been used simply as a means to explain sentimental price movement]
From its inception in 2009/2010 when it was worth nothing, to 2017 when the “hoper and dreamer” investor started to jump on board, there can be no fundamental reason for why Bitcoin would rally so hard and fast.
But stocks do the same.
Think back to the Tech Crunch in 2000. The GFC in 2007/08 or the subsequent Bull market that we are still at the tail end of now (2018).
The Volatility Index (VIX)
There are a few methods you can adopt. First and foremost, I recommend you become familiar with the Volatility Index (VIX).
The VIX is calculated by the Chicago Board Options Exchange (CBOE). So it is a reputable source. It measures the market’s expectation of 30-day volatility using the implied volatilities of a wide range of S&P500 index options.
Is that a bit too confusing? Sorry, but that’s the simplest explanation.
The S&P500 index, for those unfamiliar, is a broad index that represents the top 500 stocks by market capitalisation (value) listed on the US markets. Options are a contract that derive from an underlying such as stocks, but in the case of the VIX, CBOE measures the implied volatility from Index Options where the underlying is the S&P500 index.
So the VIX provides us with a review of volatility of the top 500 companies in the US markets.
Amongst traders and analysts, the VIX is referred to as the “Investor Fear Gauge”. The reason why is due to how the VIX moves against the broader market. Let’s take a look at a few examples.
Normal Bullish (uptrending) market
As the picture depicts, when the S&P500 index (broad market) is shifting higher, the VIX consolidates sideways.
This chart is for the period of Sept 2017 through to Jan 2018 when the S&P500 index gained approximately 15% in a steady upwards trend. At the same time, the VIX remained mostly sideways, hovering above 9 points, but ‘popping’ up to 13.50/14 points 4 times.
Compare this to a period where the markets declined.
10% ‘Pullback’ from market highs
When the S&P500 peaked in January 2018 with a 10% pullback into early February 2018, the VIX index spiked severely compared to the Bull market period.
The VIX actually peaked around 50.30 points on the 6th February, where the S&P500 index had declined approximately 9.5% from its peak to the low on the same day.
Bear Market behaviour or Market Crash
At the height of the GFC in October 2008, the VIX index peaked at 96.40 points. Throughout the bear market that was established between mid-2007 and March 2009, the VIX mostly operated in a range between 15 points and 35 points.
It is the rarity of a sharp decline in the markets that makes the VIX spike.
How to read and use the VIX for trading decisions
Like with all methods of analysis, I don’t like to use them as a “Predictive” way of reading the markets. I’m not in the game of guessing what might happen!
But the VIX can give us insight into the strength or weakness of investor sentiment. Marry that up with Technical Analysis, your Fundamental base and the Economic environment, and you can form a robust decision making process.
The first rule of thumb for the VIX is to define its ‘zone’ with the market trend that is in place. As previously mentioned, in a Bull market the VIX will consolidate. Identify the base range of that sideways trend and the upper range where the VIX reacts to normal market pullbacks.
Next, if the VIX starts to break or test that upper range, yet the broader trend of the S&P500 index remains in a steady trend, this is a warning for a potential shift in market sentiment. Consider it an early warning, but I do not act on this alone. My market/trend analysis must also trigger, along with any major changes in economic data.
A real insight into changing market behaviour is when the VIX rises at the same time as the S&P500 index. So prices in stocks have broadly risen, but at the same time investor uncertainty has increased. Again, this is an early warning alert that can have an influence on new positions or tightening of exit strategy on existing positions.
Don’t chase the VIX. If the VIX has shifted, you’ve already missed the boat. Unless there has been a change in the primary trend of the S&P500 index, you would be looking for when the VIX starts to settle back down. Especially if it has peaked around 50 points, which is typically the high level attained with a 10% pullback in the S&P500.
Never Short the VIX. The risk is for a falling market, which causes the VIX to rise. If the VIX is high, or extremely high, there is something going on the markets. Yes, the VIX will consolidate and retrace at some point, but if there is something going on in the markets that has caused the VIX to spike, there could be a lot of volatility until it starts to consolidate. There is too much Risk to the upside on the VIX.
Trading Strategy Tip
One of the approaches I use from time to time is what I refer to as a “Sleeper Trade” on the VIX.
When the markets are trending upwards, if I identify that the S&P500 is in an Overbought environment and the VIX is trading near its low base, I might adopt a longer dated VIX call option position (either as a Long Call, or a Call Debit Spread).
I’m not expecting the VIX to make me millions. This is a very small position just to capitalise on the markets reverting back to their average (mean) when it is a little too high. It’s not an expectation for a Bear market or market crash.
For Option traders, the VIX is the trickiest of derivative markets. So you need to really understand its’ unique option dynamics in Time Decay, IV, and Delta. It’s not a beginners trade, but it is one I like to adopt from time to time.
The VIX index can give you some great insight into the broader market sentiment. Especially if you are a nervous investor who jumps at every little 2% downwards movement in the market.
As you develop your understanding of market behaviour, using the VIX, and using Option Implied Volatility for a stock can provide great insight for when to adopt certain strategies that would be best suited at the time.
But Option Implied Volatility is a topic for another lesson.