Many option traders believe that the CBOE Volatility Index (VIX) can help predict bullish or bearish market sentiment. The VIX is calculated using the implied volatilities of put and call options that are currently trading on the S&P 500 Index (SPX).
In fact, some people view the VIX as a measure of fear in the market. If the old saying that “the market is driven by two things: fear and greed” is true, then having a way to measure one of these items could be beneficial.
However, in recent years the VIX has arguably become less effective. Put/call ratios, another market-sentiment statistic, may be a potential alternative. We’ll discuss the pros and cons of each of these ways to track volatility.
There’s No Crystal Ball
I think there’s little doubt the VIX reacts to the market: It seems to nearly always draw a perfect mirror image of the movement of the SPX. However, it rarely — if ever — predicts the SPX. I have charted and studied the VIX for many years and while there are short periods of time when it does seem to lead the market, I haven’t seen the VIX forecast the future with any consistency.
While the idea of a “fear gauge” may seem appealing, it’s more accurate to think of the VIX as a possible measure of market uncertainty. In the market, uncertainty about the future is often described as “implied volatility.” Simply put, the more uncertain the market is about the future, the higher the implied volatility; the less uncertain, the lower.
Unfortunately, volatility is non-directional, so while the VIX may be able to predict some kind of market movement, it can’t possibly predict the direction in which the market may move.
The VIX Has Been Less Effective In Recent Years
Back in the late 1990s, subscribers to the VIX theory believed that levels above 30 (the green line in the chart below) were bullish, while levels below 20 (red line) were bearish. Because the VIX was considered a contrarian indicator, the thought was basically that rising or high volatilities were considered bullish, while declining or low volatilities were considered bearish.
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I’ve been skeptical about the value of this indicator and these sentiment levels for years, yet you’ll find many traders who believe in them. From my own research, I’ve found that when the VIX hits extremely high levels (indicating extreme uncertainty) or extremely low levels (indicating extreme complacency), the market will often reverse directions.
The problem with measuring extremes, however, is that they’re all relative. A VIX level of 20 would have been considered extreme in 2005 or 2006, but so far in 2008, it has been at the low end of the range.
In fact, as you can see in the weekly VIX chart below, for virtually the entire period from late 2003 until mid-2007, the VIX was below 20. During this time, however, the broad market, as indicated by the SPX (pink line), was in a solidly bullish trend. Any option trader betting that the market would break down at some point (since the VIX was moving deeper and deeper below the 20 line) has probably been wiped out by now.
So what’s an option trader to do? There must be something else we can watch to get a sense of where we are headed.
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Another Option: Put/Call Ratios
Put/call ratios are market-sentiment statistics that have been around for quite some time and enjoy a faithful following among option traders. There are two main types of put/call ratios: one based on daily volume, and one based on open interest. Both of these statistics are available in the trading window of the StreetSmart Pro software.
A put/call ratio is simply the number of put contracts divided by the number of call contracts. Just like volatility gauges, put/call ratios are usually considered contrarian indicators, which means that a high ratio (more puts than calls) may be considered bullish on the underlying securities, while a low ratio is considered bearish.
However, before you assume that this is always the case, it’s important to know what a particular ratio you might see published is actually measuring. Put/call ratios can be based on any of the following factors:
As we’ll discuss in more detail in Part II, some of these ratios do indeed seem to be contrarian, while others seem more straightforward.
Learn more about this topic in How to Track Options Volatility – Part II.
Randy Frederick is Director of Derivatives at the Schwab Center for Financial Research. To learn more about him, read his bio.
This article originally appeared on The Options Insider Web site.
