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Using Volatility Charts…A Commentary Special

By Scott "The Strategist" Fullman
July 1, 2001

Volatility is a measurement of movement. It can be compared to the supply of electric current coming into your home. Most homes and businesses have electric service that is rated at 110 volts or 220 volts. This is a measurement of pressure generated to bring the current into and distribute it throughout the building, not a measurement of the amount of electricity, which is measured in amperes. Another good analogy, for those not electrically charged, is the automobile. All cars are equipped with a speedometer, which tells the driver how fast they are moving and how many miles have been logged on that vehicle. Many cars also have a gauge that measures how hard the engine is working. This is known as the tachometer, which reports how many revolutions per minute (RPM) are being generated by the engine. The latter measurement is similar to volatility.

Analyzing volatility information is similar to evaluating the performance of an engine by looking at the RPM gauge or by checking the electric pressure in your home. The function of volatility is to determine the quality or pressure being generated by the movement of a stock or index, not the quantity of that movement. By contrast, volatility helps measure the performance of the rate of change, allowing us to determine the risk or perceived risk of a movement. There are even two different scales for measuring volatility. These scales can be used by themselves or compared to each other to help determine the risks associated with a particular instrument.

The most common form of volatility measurement is known as historic volatility or HV. This is calculated by determining the standard deviation of movement on a stock or index, and then judging how much the movement of the instrument varied from that standard deviation. HV is based on a period of time and lags behind the current movement. It is impossible to determine a current volatility level based on the movement of a security in the present since HV calculations must be based on a period of time.

Another method of determining volatility is by analyzing the trading of puts and calls. By reversing an options pricing model, we can determine the value of perceived risk based on the premiums of the options contracts. This is known as implied volatility or IV. The results of IV calculations are collected into a proprietary model, which weights the valuations based on time to expiration, exercise price to current stock price relativity, and interest. Thus the formation of the Implied Volatility Index or IV Index. Using the IV Index we can determine the quality or valuation of sentiment being placed on a stock or index based on current trading and future expectations. Ivolatility.com does an excellent job in calculating both implied volatility and historic volatility levels.

PUTTING THE RESULTS TO WORK
We need to do a little more work to make the volatility levels significant. The results of HV and IV calculations hold little value if we have nothing to compare them to. It is important to develop a relationship between current readings and past readings. Otherwise, it would be like judging the performance of an investment against nothing to determine how well you really did. It's all relative. One of the most effective methods of comparing HV or IV is to plot each day's results on a chart, allowing us to judge the results against prior figures. The chart gives us a point of reference and shows the trending movement of volatility. Below is a volatility graph that is based on the NASDAQ 100 Index (NDX). The chart has two lines, one showing the IV Index and the other depicting the 30-day HV.

Volatility chart on the NASDAQ 100 Index
Figure-I Volatility chart on the NASDAQ 100 Index (NDX).

When the IV Index reaches a low point that is near a previous low, a short-term overbought condition is reached. A "sell signal" may become evident if a sharp change in the index is detected, however a holder of a bullish position should have taken note and employed a protective strategy. Conversely, when the IV Index nears a previous high, a short-term oversold condition is normally reached. A "buy signal" may become evident if a sharp downturn occurs. This might become a good point to enact a positive strategy. Two important points to note. First, overbought and oversold readings have no time limit, and can be short in duration or long in duration. During the bull move, stock prices rose for a considerable period of time while many market indicators were overbought. The second point is that reversal signals can occur prior to a reversal move, coincident with a reversal, or after a reversal. Since these signals are based on sentiment, the actual change in opinion becomes the force that drives the signal. That is why it is important to monitor conditions carefully and to protect existing positions prior to the onset of any new movement.

INTERMEDIATE-TERM SIGNALS
Combining a 30-day HV Index with the IV Index can help to provide intermediate-term signals. When the IV Index nears an extreme, and the 30-day HV Index also nears an equivalent extreme, the probability of an intermediate-term reversal rises significantly. This is a good time to look for the formation of a reversal pattern on the daily, weekly, and monthly charts. Signals of this type may also take the form of a golden or black cross -over of two or more moving averages, or the crossing of the IV with the HV. Since these indicators are based on sentiment, a person holding a position may wish to act before an actual signal is given.

I use intermediate-term volatility signals to confirm patterns in the daily and weekly charts. A head-and-shoulders topping formation, coupled with an overbought (low) volatility reading is a sign of the need for extreme caution. This is normally a good time to take profits or purchase protective puts to hedge a long position. If a head-and- shoulders formation is detected, and an oversold implied volatility reading is present, I would maintain a cautious observation and use a penetration of the neckline, or a change in sentiment, as an indicator to turn cautious.

COMING SOON
During the next several months, we will evaluate some situations and present some examples of good and bad volatility signals. You may also wish to view our Introduction to Volatility presentation, available for download on this site. Shortly, we will introduce the second presentation on the subject of purchasing call options.

MARKET RECAP
For the first time in nearly 1 1/2 years, the major market benchmarks recorded a quarterly gain. Performance on a year-to-date and monthly basis remain negative, but the positive 6-week trend in April and May more than compensated for the weakness during the past 5- to 6-week period.

Traders and investors remain complacent ahead of the Independence Day holiday and the release of second quarter earnings results. While many companies have warned that their results will be below analysts' expectations and previous guidance, the number of warnings and the comments that accompanied them did not appear to be as negative as they were in the prior period.

Volatility levels remain toward the low end of their respective ranges for most of the benchmarks indicating a low level of concern on a short-term basis. These relatively low readings have been evident for several weeks, despite the recent negative performance of the benchmarks Activity in the markets has dried up, with traders complaining about the lack of interest on the exchange floors. Unless there is a sharp change in the trend, or some event of magnitude, volume levels are expected to remain anemic as investors and traders concentrate on resting up. Summer time, however, has been one time when trend changes have occurred in the past.

GOING ON VACATION
For those investors planning to go on holiday during the next month or so, consider the purchase of a protective put against long shares. This will help you to relax knowing that your positions are protected against a major market downturn, even if you are not monitoring the markets. This is a good opportunity to utilize such a strategy, since premiums and volatility levels are low.