Sunday, March 8, 2009

Wave 5 Volatility...

If you play the market via options, you undoubtedly pay a great deal of attention to the VIX as it is a primary determiner of the Intrinsic Value (IV) of those options. It and other volatility indexes such as the VXO are measures of the potential range of motion – volatility.

Simply put, the higher the volatility, the greater the odds of reaching price targets that are far away. If volatility is high then options writers want more money to cover their risk, thus the IV goes up as the volatility increases.

These gauges are often referred to as fear gauges. In an indirect manner that is true as large price swings often are accompanied with fear – but that relationship is not always perfect, and now is one of those times. We have had staggering losses and the volatility gauges stayed in a trading range without breaking higher… yet. Will they, or is wave 5 psychology different than wave 3 psychology? Perhaps wave 5 is one more of resignation than of a sharp spike in fear?

Remember, it’s important to get the psychology of the markets correct as it is one of the three pieces to successful investing in the marketplace. The three pieces are; the Fundamentals, the Technicals, and Psychology.

Here’s a chart showing the VIX (solid black line) against the SPX (dashed red/black line) that shows the last 9 months of market action. Note the correlation and how in wave 3 down volatility spiked, but in wave 5, so far, volatility has stayed in a range:

That means that during wave 5 you never had the opportunity to buy options with a low IV and sell with a high IV, as any profitable options trading strategy would. One way to change your strategy is to buy options that are “in-the-money.” They will thus move more in relation to price and less in relation to IV or volatility. In-the-money options, however, use less leverage and thus your profit/loss potential is diminished compared to out-of-the-money options.

Some people like to play using the VXO instead of the VIX. For one of the best articles I’ve ever read on how to play the volatility gauges during bear markets, follow this link: Trading Stock Bears .

Below is a chart showing a comparison of the VIX to the VXO. During this Bear market so far the differences have not been substantial:

There is also a site dedicated to all things regarding the volatility indexes which I keep a close eye on. They have a lot of good articles to help those not familiar understand how these gauges work and what it is they are saying: VIX and More . To learn more, when you get to that site, look over in the right margin and you’ll find a few articles with the heading “VIX - Educational Posts.” These are great articles for learning… hopefully after reading those you’ll be singing along with the Cars:

The Cars - Just what I needed: