We all know what fear is and can probably identify a market that is in fear mode,we may have even been caught up or caught out by fear in our trading.
Greed and fear are what make markets volatile. But it is the latter human emotion, fear, which causes the markets to rapidly swing, often violently downwards in a short space of time. For some reason, probably going back to prehistoric times when a carnivorous predator looked like it was about to make a meal out of us, fear and responding to danger was a matter of survival. So our brains are hard-wired to respond to fear, it's the fight or flight scenario. Our reaction to fear is almost like a reflex action, we automatically react to it without thinking too much. But it is the lack of thinking it through, analysing the situation that results in an over reaction to fear in the market, which is why traders make losses, selling at a loss-we've all done it.
If excess fear in the markets causes massive selling and crashes, then being able to measure fear, similar to the way a carpenter measures the dimensions of a bookshelf to get a precise fit, would be advantageous to the trader. Being able to gauge the market's fear would flag up an oversold market and provide the trader with buying opportunities. Equally, it might provide us with a useful clue when a market crash is likely to occur.
The VIX index, has emerged as the industry standard for a measure of expected market volatility. Traders pay close attention to the VIX index because it is a good indicator about investor sentiment and market direction.
So the VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge." The VIX CBOE Index (Chicago Board Options Exchange) shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts.
Calls and puts..what are they?
These are options which give the owners the right, but not the obligation to sell or buy a specified amount of an underlying security at a specified price within a specified time. So if an investor has an optimistic view, or bullish outlook on the market and anticipates prices to rise sometime in the future they would buy at today's price, if the price moves upwards, then their trade is in profit, which equates two current market price minus the contract price. This is known as a call option, giving the owner the right to buy shares at a predetermined price sometime in the future. For example, if a stock trades at $40 right now and you buy its call option with a $40 strike price, you have the right to purchase that stock for $40 regardless of the current stock price as long as it has not expired. Even if the stock rises to $80, you still have the right to buy that stock for $40 as long as the call option has not expired.
A put option is the reverse of a call option.
A put option is a financial contract between the buyer and seller of a securities option allowing the buyer to force the seller (or the writer of the option contract) to buy the security. In options trading, when the expects that price will go down they purchase what is known as a short position on a security. This position gives the buyer the right to sell the underlying security at an agreed-upon price (i.e. the strike price) by a certain date. For example, if you have one Mar 18 Taser 10 put, you have the right to sell 100 shares of Taser at $10 until March 2018. If shares of Taser fall to $5 and you exercise the option, you can purchase 100 shares of Taser for $5 in the market and sell the shares to the option's writer for $10 each, which means you make $500 profit (100 x ($10-$5)) on the put option. So put options are used by investors to either profit from a falling market, or for hedging their shares portfolio investment.
The more volatile the market the higher the VIX Index. In the last Financial crash the VIX was nearing the 80 USD mark.
The VIX Index is quoted in percentage points and translates very roughly into the expected change in the S&P 500 Index over the next 30 day period (then annualized). For example if the VIX is 15, this represents an expected annualized change of 15 percent, which equates to 1.25% change up or down for the S&P 500 Index over the next 30 day period. (15%/12=1.25%)
In this example a VIX of 15 would be a low volatility environment.
The VIX is calculated by measuring the PUT/CALL ratio. So when there is a lot of fear in the market option traders will buy put options in greater numbers to protect their portfolios. The VIX index will be high, which is an indication there will be a lot of volatility in the market.
Another important point to note is that VIX pricing is used to calculate near term and next term option month. In other words, it is an indicator of sentiment one month in the future, which can help us to guage the future direction of the market.
For more information on VIX check out www.cboe.com
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