By Chris Ebert

One of the most consistent truths of the stock market is that stock prices experience periods of relative quiet punctuated with periods of intense volatility. Prices may trend more or less upwards or downward or even sideways for several months, and then there will often be a period of violent moves.

The periods of relative tranquility and of violent (Dow moved 300 points today) moves form a cycle known as a volatility cycle. It can be said that the periods of tranquility represent low volatility in the cycle, while violent moves mark high volatility.

cycleThe term cycle must be used rather loosely when referring to the stock market. While cycles certainly exist, they are often haphazard and unpredictable. Sometimes a period of tranquility may last for many months or even a year or more. Other times there will be periods of volatility on what may seem to be a monthly basis, with very little tranquil time in between.

Although cycles of volatility have been around as long as stocks have been traded, it wasn’t until fairly recently that folks were able to quantify and measure volatility in a way that made the measurements meaningful. Perhaps there is no better-known measure of volatility than the VIX. The CBOE calculates and publishes the VIX to give traders a standardized measure of volatility on the S&P 500. Essentially the VIX is the S&P 500’s Volatility IndeX.

VIX is Just 20 Years Old

While people have traded stock for hundreds of years, the VIX has only been around for the last 20 years or so, since the early 1990s. There is no denying that the VIX was a great accomplishment in the financial world, an accomplishment that would have likely been impossible if not for the discovery of the Black-Scholes options-pricing formula developed in the 1970s.

Here in 2015 traders may have no idea of the advancements in trading that have occurred in just the past 40 years, first with the Black-Scholes formula and later by calculation of the VIX. But despite these monumental advancements, the Black-Scholes formula and the VIX each have important limitations. Traders today must make an effort to understand those limitations, lest they be misled.

The VIX, in spite of being a valuable indicator, is perhaps one of the most misunderstood indicators a trader will ever encounter. It is an indicator that proposes to measure volatility, yet it does not. It is also an indicator that would seem to have predictive qualities, but it rarely does.

The VIX, by its design, measures fear. Fear is not necessarily the same as volatility. That’s because greed is also a factor. Volatility, in its purest sense, represents swings in stock prices in either direction – up or down. Thus, a day when the Dow gains 300 points is just as volatile as a day when the Dow is down 300 points. Volatility is volatility, regardless of the direction of the move.

the vixVIX Does Not Equal Volatility

As many traders become aware early in their career, a great day for the Dow or the S&P is not the same as a horrible day, as far as the VIX is concerned. When the S&P has a highly-volatile upward move, the VIX tends to drop. Only a volatile sell-off in the S&P tends to cause an increase in the VIX. Right there it becomes obvious that the VIX is not measuring volatility directly. The VIX measures fear (of a sell-off) with much more sensitivity than it measures greed (associated with a rally in stocks). Thus, it is more appropriately defined as a fear index than a volatility index.

It can be confusing, especially for newer traders, to understand the distinction between volatility and fear; but it is an important distinction to make. The VIX primarily measures fear of declining stock prices, it does very little to measure greed that would tend to result in rising stock prices. A high VIX suggests fear of a sell-off in stocks, and nothing more. The VIX is almost useless for measuring greed – the type of greed that could lead to a massive rally in stocks.

So, how does one predict volatility in its purest sense – volatility meaning a massive move in stock prices in either direction? The VIX cannot do it, because the VIX only predicts downward moves. To make matters worse, the VIX usually only predicts such downward moves after the move is already underway. That is to say, the VIX doesn’t really predict sell-offs at all, it just indicates a sell-off is underway.

VIX Often a Poor Predictor

volatilityMost traders don’t need the VIX to tell them that stock prices are falling. Anyone can see falling stock prices on a chart. What traders need is a way to predict the potential for a sell-off before the sell-off begins.

It’s a lofty goal to be able to predict a sell-off in advance. Such ability could make a trader rich in a hurry. Moreover, once word started to spread, traders around the world would be drawn to acquire the same ability. Soon the whole world would be getting rich.

There’s just one problem: if everyone is getting rich, where are all the riches coming from? Someone has to lose in order for someone else to win. Eventually the world would run out of losers, and the ability to predict the future would become useless.

A less-lofty goal would be to be able to predict volatility in advance. This ability would not give a trader a guarantee of success, because the trader would not know which direction the volatility would take stock prices. Instead, the trader would simply be able to recognize and predict periods of relative tranquility and of violent moves in stock prices.

The ability to predict upcoming volatility – both low volatility and high volatility – while not necessarily giving a trader a path to riches, is nonetheless a valuable ability. Volatility can be a huge advantage or it can be a huge risk, depending on an individual’s trading style. The trader who is able to adapt the trading style to the expected level of upcoming volatility is more likely to survive and more likely to thrive.

#LSSI Helps Predict Upcoming Volatility

The #LSSI (the S&P 500 Long Straddle/Strangle Index) was designed, in part, to give traders insight into upcoming volatility. In essence, the #LSSI measures compression and tension in the stock market.

LSSI 12-27-15

Click on chart to enlarge

When stock prices are under tension, they tend to be pulled back. Many traders will recognize tension when a rally becomes overextended and a correction causes stock prices to revert to the mean. The same process causes an overextended sell-off to correct itself, as the sell-off leads to rising prices and, again, a reversion towards the mean

When stock prices are under compression, they tend to be pushed outward, away from the mean. Stocks under compression are subject to experience major breakouts when the compression is released. Traders can recognize compression when a long period of range-bound prices suddenly leads to a major breakout from the range.

The #LSSI indicates tension when it is at unusually high levels, particularly above +4%.

The #LSSI indicates compression when it is unusually low, particularly below -6%.

#LSSI Predicts Volatility in Early 2016

Currently, as of the last week of 2015, the #LSSI has reached extremely low levels, below -6%. That is an indication that stock prices are under extreme compression. Such compression cannot last forever. The built up energy must somehow be released, just like a spring that has been compressed. Stock prices are poised to experience a major breakout from their current range.

The start of 2016 is therefore likely to experience violent moves in stock prices. The #LSSI cannot predict the direction of the move. Even so, traders may want to prepare their portfolios so that a major move in stock prices would not lead to bankruptcy.

Traders who have funds with which to speculate may view the prospect of upcoming volatility as an opportunity to speculate. Traders who use options to profit from a breakout, particularly Long Straddles and Long Strangles, may see the potential for a breakout as an option-buying opportunity. And traders who are sitting on the sidelines at the end of 2015 may want to just pop some popcorn and sit back and watch the show in early 2016. It’s likely to be an action picture.

* Option strategies referenced above are analyzed for profit or loss on expiration day only and are opened using an at-the-money strike price, 4-months to expiration, using options traded on a broad-based ETF such as $SPY (NYSEARCA:SPY)

The preceding is a post by Christopher Ebert, Chief Options Strategist at Astrology Traders (which offers subscribers unique stock-trading perspectives and options education) and co-author of the popular option trading book “Show Me Your Options!” Chris uses his engineering background to mix and match options as a means of preserving portfolio wealth while outpacing inflation. Questions about constructing a specific option trade, or option trading in general, may be entered in the comment section below, or emailed to OptionScientist@zentrader.ca

twitter

Related Options Posts:

A Primer on Bear Market Stage 7

Thursday Evening Options Brief 10-Dec-2015

Options Decay Nights, Weekends and Holidays

Leave a Reply

You must be logged in to post a comment.