Volatility is a term that almost every trader is familiar with but it is also a term many traders may not fully understand. The textbook definition of volatility isn’t very useful to many traders and that can lead to misperceptions. When properly understood, traders can benefit a great deal from volatility.
For some reason, volatility is usually considered to be equivalent to risk. This seems to have grown out of the way risk is defined in the academic community. In financial theory, the idea of volatility is defined as the amount a stock goes up and down in price and is used more or less interchangeably with the term “risk,” perhaps because risk has been defined quantitatively as the standard deviation of returns. Since the academic community believes returns follow a random walk and are impossible to predict in advance, they consider up and down moves equally likely and therefore equally risky.
Based on the academic definition of risk, each of the curves in the chart below is defined as being equally risky. The blue line labelled as Y is the market return. The red line is a manager who outperformed the market for most of the time period and the black line is a manager that underperformed for most of the period. Each is equally risky by definition but investors would view the two managers in different terms.
The chart above covers a hypothetical 30-year timeframe. Even through risk was the same in the long run, for the first 25 years many investors would have preferred returns that followed the red line since those were better than the market returns. In the last five years, many investors would prefer the returns shown as the black line since they were better in the short run. At almost no time would volatility have been a meaningful consideration for investors.
That’s the problem with looking at volatility as risk. Many investors want upside volatility because that can result in market-beating returns. What they want to avoid is downside volatility because that leads to large losses.
To capture what investors are truly concerned with, many experts use the Sortino ratio which compares annualized returns to downside volatility.
This might be the best measure of risk for many investors to consider since it penalizes investments for downside volatility while most risk metrics also penalize upside volatility.
As the example demonstrates, not all volatility is bad and, in fact, some volatility is rewarding. This is especially true for options traders.
Options prices are found using partial differential equations that include variables for the stock’s price, its volatility, the time left until expiration and the interest rate available on alternative investments.
Volatility is probably the most important variable in the equation and no one ever knows precisely what the volatility of a stock will be. Pricing formulas use an estimate for volatility. Studies have shown this estimation process is adequate for short-term trading because the future is usually fairly similar to the past in the short run.
Investors have developed several indicators to measure the estimated volatility. VIX is probably the best known volatility indicator. It is more formally known as the CBOE Market Volatility Index. VIX is calculated by applying options pricing formulas to futures contracts on the S&P 500. The math is complex but we don’t have to know how to calculate VIX in order to use the index.
Less formally, VIX is known as the “fear index” because it tends to rise sharply when prices fall. High levels of VIX are seen when there is a high level of fear among investors. This behavior shows that investors react to price declines by expecting volatility and market instability to increase. Let’s look at a picture. The chart below shows VIX spikes higher as stocks spike lower. Stocks are represented by the SPDR S&P 500 ETF (NYSE: SPY).
VIX tends to move much more than SPY in percentage terms. During the bear market that began in 2008, SPY fell more than 55% while VIX rose more than 420%.
We know what a percentage move in the ETF meant. Investors lost more than 55% of the dollar value of their account. The percentage change in VIX indicates traders expect increased volatility in stocks even if it is more difficult to visualize exactly what that means.
VIX is telling us the number of percentage points that traders expect the S&P 500 index to move over the next 30 days on an annualized basis. When VIX is at 15, traders expect the S&P to move about 1.25% over the next month (15% in a year divided by 12 months). This is about the normal trading range of the stock market over a month. When VIX is at 50, traders are expecting to see the S&P 500 move more than 4.5% in the next month (50% divided by 12 months), about three times more volatile than normal.
This is valuable information but VIX isn’t telling us which way traders expect prices to move, the indicator is just telling us how much they think prices will move. Prices might move up or down after VIX rises.
Remember that volatility is a factor in options pricing. When VIX is high, options pricing is high. But VIX moves up and down which means options prices will sometimes be overvalued (when volatility is high) and sometimes options will be undervalued (when volatility is low). This is a useful relationship if we can determine when volatility is about to fall. While no one can predict the future, we can use a trend following indicator to spot changes in the level of volatility.
The chart below shows VIX with a moving average (MA). An MA is calculated with the most recent closing prices. In the chart below, we are using weekly data and a 13-week MA. Thirteen weeks is about three months or one-quarter of the year and is a value commonly used to calculate MAs.
There are clear times when volatility is above the MA and other times when it is below the MA. When VIX falls below the MA, volatility is shifting from high to low. Since volatility is a factor in options pricing, this relationship can be a timing tool for options traders.
When VIX crosses above its MA, that is a sign fear is rising and traders expect prices to fall. That is an ideal time to buy put options which increase in value as prices fall. The options should also increase in value as volatility rises. They could be held until VIX falls back below its MA.
When VIX falls below its MA, that indicates volatility is falling. Since volatility is an important factor in options pricing, this could be an ideal time to sell options. Traders can sell options to generate income. Selling when volatility is falling, with naked puts or covered calls, could allow traders to benefit from the market trend and the decrease ion volatility.
Selling put options is a strategy that benefits from rising prices. If a stock is trading at $100 and you expect prices to rise, you could sell a put option with a strike price of $85. As long as the stock remains above $85, you profit from the trade. By selling the option when VIX falls below its MA, you should be able to maximize the income from this trade while minimizing risk because we expect the market to rise.
Volatility is feared by many traders, possibly because it is misunderstood. Rather than fearing volatility, traders who understand exactly what it is can use volatility as a market timing tool.