Wednesday, December 14, 2011

Market volatility changes can warn of impending trend changes in price

Market volatility changes can warn of impending trend changes in price.  Option and futures premiums increase due to an increase in volatility.  There are two major Indices that track volatility.  The first is the VIX or Volatility Index.  Developed in 1993, the CBOE's volatility index is a measure of volatility of the US equity market.  The VIX is calculated by taking the weighted average of the implied volatilities of eight OEX calls and puts with an average time to maturity of 30 days.  Most often it is considered a contrarian indicator, where high reading are considered oversold territory and low readings are overbought.  Notice as well that volatility measures often move inversely to the price trend of major indices. 

Rising volatility often confirms expectation of declining markets and corresponds with downward moving prices.  Falling volatility often accompanies rising markets and supports a bullish outlook in near term.  These are only indications but can be used to help build supporting evidence of price trend.  A confirming VIX reading supports price trend indications present in the markets.  A VIX that is not confirming price trend may suggest that the price trend is suspect. 

Volatility usually moves inversely to price trends.
The second measure of volatility found in the market place is the CBOE Nasdaq Volatility Index.  One use in tracking volatility for option traders is in recalculating option price projections based on projected changes in volatility.  Determining the current volatility and extrapolating future possible values of volatility allows option traders to use option pricing systems like the Black Schoels to calculate possible price projections for an option given an expected volatility. 

A declining volatility level over time suggest that bullish sentiment exists in the markets for the longer term price trend.  A rising volatility level over time carries bearish sentiment.  Tracking volatility allows a glimpse of what traders feel are the possibilities of price trend in the near term.  Falling values in volatility suggest a bullish bias.  Rising volatility levels suggest a bearish bias.