May 4, 2007, Newsletter Issue #65: Implied Volatility

Tip of the Week

Volatility reflects the propensity of the underlying stock to fluctuate either up or down. Premiums for at-the-money options are directly proportional to the expected volatility of the underlying stock. Implied volatility is the assumption of a stock´s volatility that helps determine an option´s price. Since all other factors in the options pricing model (stock price, strike price, time until expiration, interest rates, and dividend status) are assumed to be known, the implied volatility is calculated last as a "plug factor" after other options pricing components are incorporated.

Implied volatility numbers are a measure of the "relative" cost of an option and are loosely based on the actual, or historical, volatility of the underlying security. In essence, implied volatilities are driven by market expectations of the underlying stock. For example, let´s look at a stable blue chip stock (A) and a newly issued technology stock (B), which are both priced at $50 per share. If the price of an October 50 call option is $2 for stock A and $4 for stock B, speculators are anticipating that stock B´s price will fluctuate more than stock A. As a result, the stock B option has a higher implied volatility.

To predict future market moves we must examine the implied volatilities for the underlying market on a relatively wide scale. The Chicago Board Options Exchange Market Volatility Index (VIX) has historically been an excellent barometer for the relative level of premiums that options traders have had to pay. The VIX gauges expected market volatility over the next 30 calendar days by calculating a weighted average of the implied volatilities of eight OEX calls and puts that have an average time to maturity of 30 days. Although their trading volume has declined, OEX options are still among the most liquid in today´s market. Therefore, the implied volatilities of OEX options are the most accurate measure of the broader market´s volatility, and, consequently, will enhance our ability to more accurately predict future market movement.

The VIX´s reaction to a short market pullback is an excellent indicator of how market participants are currently reacting to the market and what they expect will follow. If market weakness is met with an increased demand for puts, the VIX will spike upwards. Such spikes are a telltale sign of fear in the market - a very healthy and bullish view for proponents of Expectational Analysis®, as speculators will tend to buy puts after they have sold out of their long positions. This often signals an end to short-term selling pressure. If the VIX does not increase on a pullback, it signals that the public is meeting the market downturn with complacency and has expectations of a quick recovery. In these cases, there is often more downside movement to follow. As such, the VIX plays a key role in our ability to predict future market performance.

Extreme high and low VIX readings can provide good contrarian signals, though it actually doesn´t matter where the reading lies on an absolute basis if it is at an extreme relative to its recent readings. Buy signals often occur as the VIX reverses lower after an extreme peak, while sell signals occur as the VIX moves higher off an extreme bottom.

A more recent addition to the arsenal of sentiment analysis is the Nasdaq-100 Trust Volatility Index (QQV), which was introduced at the beginning of 2001. Similar to the VIX, the QQV measures investor sentiment regarding the future volatility of the Nasdaq-100 Trust (QQQ). The QQQ approximates 1/40th of the Nasdaq 100 Index (NDX), which contains the 100 biggest names in the technology sector.

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