Lessons from the Pros

Lower Volatility Should Lead to Lowered Expectations

As measured by the Volatility Index (VIX), the market’s rate of change over the last seven months has fallen dramatically. The chart below shows the steep decline in the VIX from the unprecedented levels seen last fall.

Figure 1

A simplified explanation – I’ll leave the more complex details for our excellent options instructors – of the Chicago Board Options Exchange Volatility Index (VIX) is that it is derived from the calculation of the weighted average of implied volatility for Standard and Poor’s 500 Index options (SPX calls and puts), which is then used to measure the volatility of the market.

So what does a low or high reading of the VIX mean for traders? First, the current level suggests that investors have increased their appetite for risk. By and large, in a raising market, investors feel good about their prospects for making money, and are less concerned about risk. As a trader, however, you should become more keenly aware of major resistance points, or breaks of support levels, as the market is becoming increasingly riskier. Moreover, changes in bullish market behavior when the VIX has fallen sharply may be a clue of an imminent correction, as these usually occur when investors are the most complacent.

Conversely, when the VIX is at lofty levels, fear is rampant, and investors have become risk averse. These times are to be looked at as low risk buying opportunities.

From a historical perspective (which is very important in gauging most recent sentiment), the market tends to go through multi-year periods of high and low volatility. The chart below depicts these patterns, and poses the question whether we are in a new paradigm.

To answer that question, first, I believe that the record levels reached last November were an anomaly, and thus a more realistic range going forward would be between 30 and 60. Since the current reading is roughly around 29, it seems to me that we’re at the lower end of the range, which implies higher volatility in coming weeks, and perhaps for several years.

Figure 2

One more consideration in a constantly changing landscape of volatility (and maybe the most important for a trader) is the adjustments that have to be made.

For example, in the chart show below, we can see that last October, the average true range (histogram) for the ES (E-mini S&P 500) was 80 points; this coincided with the VIX spiking to 90 on an intraday basis. The recent range is down to 20 points and on some days much lower.

Figure 3

When engaging in these drastically different environments, one must first think in terms of modifying risk parameters. This can be done by adjusting the distance used to place stops as well as reducing, or increasing contract size.

Additionally, one must manage expectations when encountering diverse levels of volatility. What do I mean by this? Lately, the market has tended to trade in tight ranges for hours at a time. An extreme example was June 4th in which the ES (E-mini S&P) traded in a 3-point range for three and a half hours. This is quite a contrast to the 10-point moves occurring in 5 minutes late last year. Accordingly, the anticipated risk-to-reward ratios should be more realistic and in line with the present environment.

Let’s redirect our focus to the market. In my last newsletter, I made mention of the trading range the S&P found itself in. I also cited the rise in interest rates as a possible countervailing force on higher stock prices. Well, yields continue to climb, and so has the market, to some degree. On May 29, the ES broke out above its one-month range (lower chart) and has now begun a fresh trading range, this one much narrower.

Figure 4

Admittedly, the resilience of this market in the face of underlying negatives is somewhat surprising. These negatives are not only fundamental (record foreclosures, rising rates, high unemployment) but also technical (lower volume, lagging financials, and declining breadth) just to name a few. Regardless, there are times when the market takes on a life of its own, and when that happens, there’s very little that can stop its movement.

The key to the market’s future direction, I believe, is in the bond market. Therefore, interest rates should be closely monitored, because sooner or later, something will have to give.

Until next time, I hope everyone has a profitable week.

If you have questions or comments, please email me at gvelazquez@tradingacademy.com

- Gabe Velazquez