As I have already stated, volatility is an ethereal subject. It is one which is constantly in the spotlight as traders try to expose its hidden secrets. Over the decades there have been many attempts to make sense of the term, and to convert the concept into meaningful charts, and leading the way has been the CME (Chicago Mercantile Exchange), and more recently the CBOE (Chicago Board Options Exchange). Each exchange has produced an increasingly diverse range of products to help traders make sense of the volatility conundrum.
Volatility indices is where the world of vanilla options and binary options meet, albeit on nodding terms only.The principle behind all volatility indices is very simple. Their purpose is to present the market’s expectation of implied volatility. In other words, to provide a forecast of where volatility is heading in the future. Historic volatility is all well and good, but it is just that – historic. It certainly has a place when considered in conjunction with implied volatility, but for traders, it’s all about the future.
This is what a volatility index is attempting to do – to forecast where volatility is heading for that instrument and in that timeframe. For a 30 day index, it is forecasting implied volatility in the next 30 days. For a 9 day index, it is the next 9 days.The basis for all these calculations are vanilla options, both calls and puts, which is why I said this is where binary and vanilla options meet. Speak to any options trader, whether electronic or from the pit, and the one aspect they all focus on is implied volatility.
As with everything in trading, forecasting the future is very difficult, and implied volatility can be just as tricky. But at least it’s a place to start and can provide the framework for trading both binary options as well as more conventional instruments. As we go through the indices, I will try to highlight some of the underlying methodologies, without too much reference to the maths, as I believe understanding how to use them and where to find them is much more important.
Moreover, you do not need a futures brokerage account to discover this information for yourself. Most is freely available, but of course with a futures account and feed, you will be able to see live intraday prices – whilst the free versions are generally delayed (although not greatly).The guiding principle for all volatility indices is relatively straightforward. Each analyzes the underlying put and call options to gauge whether speculators, traders and investors are either bullish, bearish or neutral, and to gauge the extent of this sentiment.
At the simplest level, call options are generally bought when sentiment is bullish, and put options when sentiment is bearish. It is the analysis and interpretation of the underlying options for an instrument or market which are described graphically in the form of an index. The chart describes the market’s expectation for the future (implied volatility), based on what is happening in the buying and selling of options in the present.
VIX:The VIX is the granddaddy and an index you may have already come across. It was originally introduced by the CBOE in 1993 as an attempt to measure the volatility associated with US stock markets. The index quickly became the benchmark for forecasting volatility over a 30 day period, and it is often referred to (myself included) as the ‘fear index’. The initial index calculated implied volatility based on at the money options for the S&P 100. This underlying methodology was replaced in 2003, along with two major changes.
First, the S&P 500 was used as the benchmark, and second the analysis included options with a range of strike prices, duly weighted and covering both near and next term expiry. Until this change in the underlying methodology, the VIX had been considered somewhat abstract and lacking in any real meaning for traders. The index was interesting from an academic perspective, but not much use for trading.
The changes in 2003 provided the basis for the product to be launched as a futures instrument in 2004, followed by VIX options in 2006.However, there are a couple of points I have to make clear. First, whilst the VIX is forecasting implied volatility over the next thirty days, the timeframe for analysis is not limited to 30 days. As a futures contract in its own right, prices are quoted intraday just as for any other market or instrument.
So just as for any other index (whether cash or a future) the VIX will rise and fall throughout the day. The index can therefore be considered on any timeframe from tick to hours and from daily to weekly. Intraday scalping traders in the futures and options markets will have a workspace devoted entirely to the VIX. This workspace provides a complete picture of changes in volatility on a second by second basis, as the underlying options are bought and sold to reflect changes in sentiment.