Volatility is an indicator

Volatility is an indicator

Investors are sometimes intimidated by derivatives. The perception is that one must be a rocket surgeon to understand this next order of trading instruments. The reality is simpler. Even investors who failed high school mathematics can garner valuable information from derivative markets.

The Volatility Index (VIX) is a higher visibility output of options markets. Known as the “fear and greed” index, it is calculated by ratings agency Standard and Poors. When market fear is high, so is the VIX. A lower VIX is a sign of greed, or at least investor complacency. The level and direction of the VIX may give vital clues to where an index is headed.

The original VIX gave information about the S&P 500 Index in the US, but S&P now calculate VIX indices over many markets, including the Australia 200 Index. This means the light that a VIX sheds on a market’s potential is available to local investors, and may be especially useful to those implementing an active strategy. The local version is known as the A-VIX.

What is a volatility index?

To understand the Australian VIX investors need to know a little about volatility. It is measure of the daily variation of a share or index (or indeed any tradeable instrument such as a currency, commodity or bank bill).  Volatilities are calculated over a specified period. In share markets 30, 60, 90 and 180 day volatilities are most common.

Volatilities are expressed as a percentage per annum. As a rough rule of thumb, investors can calculate the average daily move by dividing the volatility by 16. A stock with a volatility of 32% p.a for a given period has an average daily move of 2% for that period. The daily move is measured as the difference between the closing prices, one day to another.

There’s one more wrinkle to volatility to discuss. In broad terms there are two kinds of volatility; historical and implied. Historical volatility looks back, and is calculated from the actual closing prices of the index over the last 30, 60 or whatever days. Implied volatility looks forward. It is calculated by reverse engineering option prices. One way to think of implied volatility is that it is an estimate by market professionals of the likely volatility of the index over the coming 30, 60 or whatever days.

Working out the value of the VIX is a complicated mathematical procedure, but the principle is straightforward. The VIX is calculated by reverse engineering near month options. It is a measure of the professional consensus estimate of how sharply the market will move over roughly the next month.

One of the main reasons that fund managers find volatility-based instruments so useful is that volatility generally moves in the opposite direction to the market. Inverse correlations are very valuable to professional investors as they can be used to lower overall portfolio risk.

It is this same quality that makes the VIX valuable to individual investors. When the A-VIX is low it’ s a sign that market confidence is high. However when the A-VIX starts to move up from lower levels it means that option traders are lifting their estimates of the volatility to come. This could reflect traders’ views of current conditions, an event packed market calendar, or increased demand for the portfolio “insurance” that options provide.

Signals from the volatility index

Whatever the reason, the A-VIX moving higher from lows is a sell signal for the Australia 200 Index.

Similarly, when the market falls hard, the A-VIX spikes higher. A sign that the market may recover from a recent sell down is the A-VIX pulling back from the spike highs.

The recent ranges for the A-VIX point to two potentials signal areas. When the volatility index trades between 10% and 12%, and then climbs over 12%, active investors may consider trimming their portfolios. Whenever the A-VIX climbs over 20% it is in fear territory, and it cans spike substantially higher than this point. However as it drops back through 20% it may also provide a buy signal to alert investors.

Active investment is more difficult than a simple buy and hold approach. In the face of this difficulty some investors throw their hands in the air and declare “timing the market is impossible”. Others may use the available information to get better at it.

This article first appeared in the Australian Financial Review.