April 27, 2004

Implied Volatility Index and related indicators:
How you can use them in trading & risk management (part III)

Continued from "Implied Volatility Index and related indicators: How you can use them in trading & risk management, part II"

Last week, we slightly touched a topic of what IV Index (IVX) values should be considered as low or high. It is clear that this depends on the "class" of underlying - is it a penny stock or blue chip? The global state of the market is to be taken into account too, for sure. In this letter we present the results of a short investigation on this topic.

IVX bands: different markets, different stocks

In our last letter, we mentioned that the current absolute level of IVX of 60 % can be considered as high, and 20 % - as low, if we are not talking about penny stocks. Now we'll try to back up this assertion and show the history of IVX levels, based on data from IVolatility.com's vast database. Have a look at a chart below - it shows the evolution of IVX bands, starting from March 2000, when the S&P 500 was at its "high of highs", through long and deep descent, stopped about a year ago, till nowadays. Blue-gray solid line shows S&P 500 price level (out of scale), other lines - conditional levels of high / low IV Index. Conventionally, we take the S&P 500 as a proxy for the general market conditions, which will help us investigating correlation between IVX levels and the market.

Chart 1. Evolution of IVX bands from March 2000 till now. Blue-gray line depicts S&P 500 level, conventional units.

For our investigation, we've sorted all of the stocks by groups, based on stock price: below $5, between $5 and $25, between $25 and $50 and above $50. By the way, "all" stocks, means all the US exchange-traded stocks having exchange-traded options, about 2500 names total. There is nothing "academic" in such segregation; rather we've used common-sense ranges. For each of the groups, there are two lines on the chart of the same color - upper line shows the higher bound for "normal" IVX values, and lower one - the lower bound.

How were these lines drawn? For each of the groups, we've taken an average value of IVX 30 Mean. We didn't perform any weighting, just the stock-wise average. To diminish the effect of "bad days", we've further averaged this data in a 1 week range. In the same fashion, the standard deviation of IVX was calculated (a measure of variation in IV Index for individual stocks).

What else do you see on the chart?

There is a good saying that "a chart is better than a thousand words". However, let us present a couple of potentially interesting conclusions, drawn from the chart.

  1. IVX bands are fairly stable from the very beginning of S&P 500 recovery back in March 2003. The market never declined considerably since then - and average IVX levels do not forecast changes to the bad, it seems.
  2. In the course of time, IVX bands become generally lower and tighter - nothing unusual, provided that options become more regulated and less risky (as everybody hopes!) of an asset.
  3. Penny stocks have higher levels and wider bands - again, this is quite natural, cheap stocks are always a risk. Note that the results for this stock group is not as accurate as for others, since there are not many stocks with price below $5 having exchange-traded options - about 80 names as of this moment. Their "normal" IVX range is 60 % - 120 % now - just above the figures for "good" stocks.
  4. As we've said, generally, average IVX level becomes lower and lower. However, it advances quite sharply for some of market declines - look at September 2000 or August 2002, for example. We are not sure why some (and not all) - seems that IVX continues its decrease (or stays constant) even when the market declines, but not too fast (no all-embracing panic). But, it jumps up when a drastic market decline occurs, after a long period of relative stagnation. For the illustration, we examine a couple of characteristic moments "under a microscope" below. The data is not averaged weekly here; also, we show only IVX for $5-25 stock group as the most representative one.

Chart 2. IVX level went up, reacting to the market downfall in September of 2000; however, IVX increasing stopped in January 2001; note also it's curious unstable behavior in March - April of 2001, before the local market uprise.

Chart 3. IVX level was quite stable prior to Jun 2002, while the market was already falling. IVX started reacting only when in July to August a relatively sharp downfall took place.

What's next?

As you see from the charts above, the relation of IV Index and the market is not that trivial, looking at the market as a whole. Although CBOE VIX�traces S&P 500 quite perfectly (almost as a mirror image), the averaged IVX of all the stocks does not possess such a behavior. But why talk about market-averaged characteristics? It's good to know them, in order to understand the general situation correctly, but commonly you trade individual stocks, right? In our next letter we'll try to show if IVX, or some IVX-based indicator is capable of predicting future stock behavior, with what accuracy and under which conditions. Especially, we will look at IVX as a predictor of Stock (Historical) Volatility, and the stock price itself.

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