If we were to scroll back ten years, all we would have found at the CBOE would have been the VIX. Now you can find volatility indices for all the benchmark equity markets, commodities, currencies and even individual stocks. In addition, with the advent of weekly options, we are increasingly beginning to see ‘weekly’ based volatility indices, bringing timeframes more in line with the binary options world.
Given the number of volatility indices available, I have decided to focus on just one or two, as the broad principles of interpretation are the same.Whilst the first three are based on a 30 day implied volatility forecast, the last of these, the VXST is one of the new generation, short term volatility indices, and is based on 9 days.And I want to take a brief look at each in turn, and the information they reveal, and how they can help us make some informed trading decisions based on the forecast volatility.
The GVZ volatility index charts implied volatility for gold over the next 30 days, and uses the same underlying methodology as for the VIX. However, in this case the index uses options on the SPDR Gold Trust ETF (GLD), one of the most heavily traded ETF funds, which is backed by the physical asset. The CBOE presents the index using six timeframes as follows, so whether you are trading intraday or even onger term, you will find all the information you need:Intraday, One week, Three month, Six month, One year, Five year.
However, implied volatility is only a forecast of future volatility – there are no guarantees the market will behave in the way it is forecast. Nevertheless, it is an excellent starting point, and by using multiple timeframes this will also help to give a complete picture of where the current forecast is in relation to the past.For example, trading a weekly binary option, whilst the weekly volatility may be high, in the context of the 3 month volatility it could be low.
It is all relative, and as with volume analysis, the key is to reference what is high, medium or low across the various timeframes. Equally, on an intraday basis, volatility may be high, but in the context of the week, may be low. All this will help to ‘frame’ the volatility and help to determine the trading decision, whether for entry or exit, or for trading strategies based on volatility, or the lack of volatility.
Before looking at some examples for the GVZ, I would like to reiterate the point I made earlier about correlations. As you begin to study this index in detail and any associated moves with the underlying GLD ETF, you will quickly realize there is no relationship that can be considered reliable in the context of correlation. As volatility rises, so the price of gold may also rise, and vice versa. But this is not the VIX.
Do not fall into the trap of believing that an inverse relationship exists – it does not. The volatility index for gold is non directional. As volatility increases the price of gold may move sharply higher or lower. It will not forecast direction. What it will do, is to provide that key piece of the jigsaw – a view on the current and future volatility, framed against the past.Whilst I have shown all six timeframes here for gold, in the other examples I only propose to highlight one or two to keep the number of schematics to a manageable number.
The intraday schematic is typical of what we might expect to see as trading moves from the electronic into the physical trading session. Gold futures will have been trading overnight on Globex, but as always the main activity in the commodity is when the physical exchange opens with the futures leading the way. This leads to a surge in volatility at the open, and in this case the index moved from 13.35 to 13.61, before sliding lower throughout the remainder of the trading session as the initial volatility drained away, no doubt associated with the price of gold trading in a relatively narrow range.
Note this says nothing about the direction, simply that the price action was volatile at the open for a relatively short period, peaked, and then declined steadily for the remainder of the day. So two points to note here.First, this gives us an intraday view of volatility as the session unfolds, and second it also lays down a marker of the expected range which can then be ‘framed’ against the volatility of the slower timeframes.
This is not to say volatility will always be in this range. It will vary depending on market conditions. However, as you begin to consider these on a regular basis, you will quickly build a picture of what is high medium or low within each timeframe. In this case, as the volatility declined past 12 pm and onwards, a ‘low volatility’ strategy may have been appropriate for entry, and for an existing position, perhaps giving the confidence to hold. This assumes there are no major news releases, or shocks to spook the market.