CBOE Volatility Index-Implied Volatility and Direction

Often traders look to the implied volatility of the market as a whole for guidance on the IV of individual stocks.Traders use the Chicago Board Options Exchange (CBOE) Volatility Indexs, or VIXs, as an indicator of
overall market volatility.When people talk about the market, they are talking about a broadbased index covering many stocks on many diverse industries. Usually, they are referring to the S&P 500.

Just as the IV of a stock may offer insight about investors’ feelings about that stock’s future volatility, the volatility of options on the S&P 500—SPX options—may tell something about the expected volatility of the market as a whole.VIX is an index published by the Chicago Board Options Exchange that measures the IV of a hypothetical 30-day option on the SPX. A 30-day option on the SPX only truly exists once a month—30 days before expiration.CBOE computes a hypothetical 30-day option by means of a weighted average of the two nearest-term months.

When the S&P 500 rises or falls, it is  common to see individual stocks rise and fall in sympathy with the index. Most stocks have some degree of market risk. When there is a perception of higher risk in the market as a whole, there can consequently be a perception of higher risk in individual stocks. The rise or fall of the IV of SPX can translate into the IV of individual stocks rising or falling.Who’s afraid of falling stock prices? Logically, declining stocks cause concern for investors in general. There is confirmation of that statement in the options market.

Just look at IV. With most stocks and indexes, there is an inverse relationship between IV and the underlying price. Exhibit 3.2 shows the SPX plotted against its 30-day IV, or the VIX.The heavier line is the SPX, and the lighter line is the VIX. Note that as the price of SPX rises, the VIX tends to decline and vice versa. When the market declines, the demand for options tends to increase. Investors hedge by buying puts. Traders speculate on momentum by buying puts and speculate on a turnaround by buying calls.

When the market moves higher,investors tend to sell their protection back and write covered calls or cashsecured
puts. Option speculators initiate option-selling strategies. There is less fear when the market is rallying. This inverse relationship of IV to the price of the underlying is not unique to the SPX; it applies to most individual stocks as well. When a stock moves lower, the market usually bids up IV, and when the stock rises, the market tends to offer IV creating downward pressure.Calculating Volatility Data:Accurate data are essential for calculating volatility.

Many of the volatility data that are readily available are useful, but unfortunately, some are not.HV is a value that is easily calculated from publicly accessible past closing prices of a stock. It’s rather straightforward. Traders can access HV from many sources. Retail traders often have access to HV from their brokerage firm. Trading firms or clearinghouses often provide professional traders with HV data. There are some excellent online resources for HV as well.HV is a calculation with little subjectivity—the numbers add up how they add up.

IV, however, can be a bit more ambiguous. It can be calculated different ways to achieve different desired outcomes; it is user-centric. Most of the time, traders consider the theoretical value to be between the bid and the ask prices. On occasion, however, a trader will calculate IV for the bid, the ask, the last trade price, or, sometimes, another value altogether.There may be a valid reason for any of these different methods for calculating IV.

For example, if a trader is long volatility and aspires to reduce his position, calculating the IV for the bid shows him what IV level can be sold to liquidate his position.Firms, online data providers, and most options-friendly brokers offer IV data. Past IV data is usually displayed graphically in what is known as a volatility chart or vol chart. Current IV is often displayed along with other data right in the option chain. One note of caution: when the current IV is displayed, however, it should always be scrutinized carefully.

Was the bid used in calculating this figure? What about the ask? How long ago was this calculation made? There are many questions that determine the accuracy of a current IV, and rarely are there any answers to support the number.Traders should trust only IV data they knowingly generated themselves using a pricing model.

Volatility Skew:There are many platforms (software or Web-based) that enable traders to solve for volatility values of multiple options within the same option class.Values of options of the same class are interrelated. Many of the model parameters are shared among the different series within the same class. But IV can be different for different options within the same class. This is referred to as the volatility skew.