A beginner question on volatility

Discussion in 'Options' started by loogling, Feb 23, 2012.

  1. loogling

    loogling

    The beginner is me. And my naive understanding is that high volatility = wide price fluctuations. This would mean that high volatility can occur in a rising market about as equally as in a falling market. But VIX index seems to show otherwise. VIX tends to fall on a rising market and vice versa. And sometimes VIX can make a big move, without any major news event, while the S&P500 index remains pretty flat. What I am missing here? I'm quite confused.
     
  2. rmorse

    rmorse ET Sponsor

    Stock tend to go down faster than they go up. Also, because most positions are long biased, a down market creates losses and fear. As a result a down market typically correlates with rising IV. An up market is generally slower and beneficial to most portfolios. So, a rising market tends to lower fear and IV. Option volatility is priced based on perception of the future, not reality.

    Your confusion is what creates opportunity. If you can pick out when perception is not pricing in your expectation of reality, you can make money.
     
  3. 1) If you look at "it" from the perspective of the daily range with respect to the index value, it may make more sense.
    2) If you assume that the Dow Jones has a daily range of 100 points, for the sake of simplicity, and the index is trending higher, the Dow-VIX will trend lower because 100 (numerator) as a percentage of an uptrending number (denominator) produces a declining number (ratio).
    3) Vice versa for a downtrending market. In reality, the daily range will get much larger during a decline which produces a much larger VIX value because of the shrinkage of the index.
    4) The VIX can diverge from its index but can be brought back into line through various arbitrages. The CBOE says the correlation of the S&P-500 and VIX is ~80%. :cool:
     
  4. VIX can rise on up days, but it's unlikely.

    The VIX is not the only volatility meter. There are lots of ways to measure volatility. Other common measurements are the CMO, RSI and MACD.

    You're not far behind me! :D Are you getting a degree in finance or interning?
     
  5. Well there's two of them- realized and implied.

    Realized is what you'd calculate using excel and what your broker's platform spits out- it's based on current price that we can all see and is going back to whatever time you want.

    Implied is forward looking and that is what the VIX was designed to capture. It takes different option prices from constituent S&P 500 components. It puts it into a fancy formula which provides a value of the VIX in real time.

    Now, options prices can be used to calculate implied volatility- kinda like using the y axis value to figure out the root on the x-axis. This is the volatility the market expects will realize in the FUTURE. Another thing to remember is that people dont like falling stocks- so put options are more expensive than calls which means that implied volatility is generally higher for puts.

    This means that the VIX itself will go up when market participant are unsure of what the market will do because option sellers jack up the premium to compensate for the higher uncertainty.

    Which is why even though the market gaps up the VIX barely moves because people like rising markets and there's less "fear".

    But you're right, the realized volatility can jump up whether the market jumps up or down.

    It's the realized thats the important one.

    Here's the paper on VIX if you're interested:

    http://www.cboe.com/micro/vix/vixwhite.pdf
     
  6. loogling

    loogling

    Thanks for the answers. I'll try to learn and make sense out of all your input. I'm not studying for any degree. Just looking into possibly trading VXX, but I don't feel confident trading something that I don't understand. For example, why does VXX drop so much today?
     
  7. It is a great question and answering the right questions can make you a ton of money.

    Have you looked at your premise about high vol in rising and high vol in falling markets? Take a charting program and see if that is really true. Also, checkout if there is any difference before and after the volatility options were created. Check the nature of the market for who is trading at any one time, how each trades in general, and how they behave in different market scenarios.

    I suspect that you are missing trader psychology. Keep asking questions!

    One more thought - confusion is the market. Beware when there is no more confusion.
     
  8. VXX is a futures contract for VIX. I wouldn't trade futures if you haven't even traded stocks or options.

    The symbol SPX is a futures contract. But its options are tradable under either the index as the underlying or the index as the future.

    Now if that didnt make sense to you, learn.

    And dont trade it.
     
  9. i strongly suggest not trading the vxx unless you are intimately familiar w/ the product which is based on the futures not the spot (no one can trade spot vix) and you understand the contango issue much like ung - the worst product invented since clear pepsi.
     
  10. TskTsk

    TskTsk

    Fear trumps greed, so a down market tends to be more volatile than an up market.
     
    #10     Feb 24, 2012