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Volatility And Key Market Turning Points

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    October 5, 2013

    The CBOE Market Volatility Index (VIX) is a well known, but oft-misunderstood financial instrument.

    As a consequence, many traders and investors perceive the usefulness of the VIX as being very limited in determining reliable signals for market direction.  What we know from experience is that there are certain combinations of price variables that can be used to significantly improve the reliability of short-term market direction signals generated by the use of the VIX – most specifically it’s use in combination with the standard deviation of price on the shorter term charts, and we look at that in detail in the second half of this week’s free video log.

    In the first half of this week’s video we review the current long term technical picture for volatility and how it is indicating a high likelihood that a period of extreme and sustained volatility lies directly ahead for equity markets.  Whilst our proprietary trend analytics do not confirm this move as being underway, many of the pre-cursor indications are evident and we now defer to our trend analytics simply to provide the technical confirmation of this move.

    Below is the Wikipedia description for the interpretation of the VIX;

    “”Although the VIX is often called the fear index, a high VIX is not necessarily bearish for stocks.[7] Instead, the VIX is a measure of market perceived volatility in either direction, including to the upside. In practical terms, when investors anticipate large upside volatility, they are unwilling to sell upside call stock options unless they receive a large premium. Option buyers will be willing to pay such high premiums only if similarly anticipating a large upside move. The resulting aggregate of increases in upside stock option call prices raises the VIX just as does the aggregate growth in downside stock put option premiums that occurs when option buyers and sellers anticipate a likely sharp move to the downside. When the market is believed as likely to soar as to plummet, writing any option that will cost the writer in the event of a sudden large move in either direction may look equally risky.

    Hence high VIX readings mean investors see significant risk that the market will move sharply, whether downward or upward. The highest VIX readings occur when investors anticipate that huge moves in either direction are likely. Only when investors perceive neither significant downside risk nor significant upside potential will the VIX be low.

    The Black–Scholes formula uses a model of stock price dynamics to estimate how an option’s value depends on the volatility of the underlying assets.””

    Confused?.  Me too.

    It’s not really that hard.  As a trading instrument it is our firm view that trading volatility is as close to poison as you can get, and invariably attempts to trade volatility end in disaster.  As such, we don’t know of any circumstances whatsoever that would warrant trading volatilty on it’s own, however as we cover in this week’s free video log – we do believe it can certainly be used in conjunction with the right variables to become a very useful part of any trader’s toolkit.

    Please enjoy the video!




    Paul Thomason

    Editor, Elliott Wave Market Service

    Images: via Flickr (licence attribution)