atility indices. One is VIX, which is the impliedvolatility of SPX options. The other is VXO, which is the impliedvolatility of OEX options. Of lesser importance, in general, are twoothers related to Nasdaq indices: QQV, which is the implied volatilityof QQQ options, and VXN, which is the implied volatility of the NDX(Nasdaq-100) options.VIX was the first of these indices to be created, and its inceptiondates back to 1993. At the time, the CBOE backdated the calculations to January 1, 1986, so that the crash of 1987 was encompassed in the data. This original VIX computed an implied volatilityfigure using OEX options. Rather than use all of the options, it onlyused eight of them: puts and calls at the two nearest months and thetwo nearest strikes to the current OEX price. This was a reliable measure, and many people came to depend on it.However, in late 2003, the CBOE changed the format of VIX.The “original” VIX was renamed VXO, and a new VIX wascreated— one that was based on the SPX options traded on theCBOE. Moreover, this new VIX used all of the options and was calculated with an entirely new formula. When this new VIX was created, the CBOE backdated it to the beginning of 1990, whichunfortunately means that the crash of 1987 was not included in thecalculations. The new VIX’s history was very similar to that ofVXO—peaks appeared at similar points in time, although perhapsnot at the exact same levels.At the time of this writing, both VIX and VXO are followed by“volatility watchers.” In the following discussions, the VXO is used todescribe the behavior of volatility for two main reasons: (1) it has alonger backdated history and (2) it was actually in use during all of themarket movements since 1993, so its history is real (not theoretical).(The reader should understand that any statements made about VXOare also true regarding VIX. They are very similar.)The entire history of VXO is shown in Figure 4.19. This chartshows the various spike peaks in implied volatility that have occurred
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THE PREDICTIVE POWER OF OPTIONSFigure 4.19CBOE’S VOLATILITY INDEX ($VXO)—ENTIRE HISTORY150
80Crashof 1987
Long-TermCapitalTerroristattackRussiandebtTech stockDow limitmassacre *down 550
Volatility
60IraqinvadesKuwait
40
Gulf War
UAL
20
* Iraqwar
Fed raisesrates
/02
/0312/31
/01
12/31
/00
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/99
12/21
/98
12/27
/97
12/24
/96
12/23
/95
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/94
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/91
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/90
12/27
/88
/87
/89
12/26
12/27
12/28
12/30
12/31
/86
0
*Bear market panic bottoms.
over the years, and all were eventually important buy signals. Bylooking at Figure 4.19, you can see the biggest panic peaks in VXO,from the crash of 1987, through the Gulf War, to the panic bottomsin October 1997 and 1998 and the terrorist attack on 9/11/2001,through the bear market bottoms in 2002 and 2003.While the OEX chart is not shown in Figure 4.19, one can easilyverify that each of these spike peaks in volatility was an excellentintermediate-term buy point. Just when everyone else was panickingand rushing to buy puts—at outrageous prices—the market was bottoming—a classic contrarian situation.Other things are also apparent from the long-term chart in Figure 4.19. One is that VXO trades at all sorts of different levels—from10 to 60 and above. Thus, it is incorrect to say that a fixed level ofVXO is a buy signal (or a sell signal). On the one hand, some of thespike peaks occurred with VXO in the low to mid-20s (Gulf War orwhen the Federal Reserve System raised rates in 1994). On theother hand, VXO rarely ever traded below 20 from 1996 through2002. So, a dynamic interpretation is necessary, as it is with most
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market indicators. One identifies spike peaks, wherever they mightoccur, as long as they accompany a swiftly declining OEX.The long history of VXO in Figure 4.19 shows several distinctperiods and trading ranges. First, there was the 1986–1990 timeperiod, when VXO often traded above 20 and large spikes occurredat the 30 level or higher (not to mention the 150 level reached in thecrash of 1987—a level never even approached since). But then themarket became docile from 1991through 1995, with VXO tradingdown its all-time lows below 10 and rarely getting above 20. However, that all began to change in 1996, when VXO increased allyear. Then, from 1997 through about the first half of 2003, VXOwas consistently volatile—probably averaging near 30. Suddenly,the bull market that sprang up in March 2003 issued in a period ofsteeply declining volatility, taking VXO down to levels not seen ineight years. So, VXO can change complexion, and it is the job ofthe strategist to notice these changes and follow along with them—not picking some fixed level of VXO as “expensive” or “cheap” andstubbornly refusing to yield even as VXO makes a new extreme highor low.What happens when VXO is “too low”? Is this a sell signal? Actually, no, not always—sometimes it is, sometimes it isn’t. In fact,when VXO is “too low,” that means the market is about to explodein one direction or the other, but it is often uncertain as to whichdirection that will be. We can offer some guidance on this issue,though.But first, let’s examine why a low VIX or VXO reading meansthat the market could explode in either direction. Remember, whenthe volatility indices are at extremes, it is sentiment that is pushingthem there. When they are very expensive, option traders are panicking and buying puts at any price just as the market bottoms. Conversely, when VXO is very low, what is going on in the optionmarket? Option sellers are aggressive and buyers are timid, and thuspremiums decline. Their true expectations are that the market isn’tgoing to do much of anything. That’s why they’re willing to sell premium at such low prices. Of course, when “everyone” thinks themarket is going nowhere then—by contrarian analysis—it is destinedto go somewhere, and fast! Hence it explodes. This concept is truewhether the underlying is an index, stock, or futures contract.
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In order to illustrate this, it would be a fairly simple matter tomark the low points in volatility on Figure 4.19 and see what happened to OEX or SPX after each low in volatility. In fact, we constructed such a study. Consider Figure 4.20, a long-term (10-year)graph of OEX in lognormal format so that price changes can moreeasily be seen in the early years. On this graph are a number ofboxes. The shaded boxes indicate downdrafts in the market, whilethe clear boxes indicate short-term uptrends. The left side of theseboxes was placed on the graph coincident with lows in volatility. Wedefine a low in VXO as the following: it is not preceded by a lowerVXO reading for 60 days nor succeeded by a lower reading for 30days. Hence, a low defined in that manner is truly a low—not justsome temporary thing, but a true low over a three-month period.Those lows don’t occur too often, only about once or twice a year.Whenever one of those lows occurred, we started a box on Figure4.20 and then observed what the market did.
Figure 4.20$OEX MOVEMENTS AFTER LOW $VIX READINGS
3603403203002802602402202001994 1995 1996 1997 1998 1999 2000 2001 2002 2003
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You can see that the shaded boxes (market declines) and theclear boxes (market rallies), are about equal in number. Even moreinteresting, though, is the fact that most of the clear boxes occurredduring the big bull market of the 1990s, while most of the shadedboxes occurred after the bear market began in 2000. So, we mightbe able to draw an even more refined conclusion: after a true low inVXO, the market makes an explosive move, usually in the directionof the primary trend in the market at the time.Many traders feel that a low in volatility precedes a declining market—and that was certainly true in 2000 through early 2003. But itwas clearly not true back in 1995, for example. One of the largestmarket rallies—a straight up move that lasted about 10 months—wasborn after one of the lowest VXO readings in history (in February1995). So, once again, it is important to use a dynamic approachand not get locked into adages that are wrong, such as “The marketalways declines after a bottom in VIX.” It just isn’t true.Some readers may want to know more about why this is true,because it is often stated that as a stock rises, its volatility eventually decreases. That is true, in general, and was discussed earlierwhen comparing the behavior of a $5 stock with that of a $100stock. But if any market advances in a herky-jerky manner, thenvolatility will increase for a while. What many traders don’t realize isthat volatility is computed as a statistical measure. It is actually thestandard deviation of the percentage daily price changes of theunderlying instrument. This use of percent changes is what makesthe analysis lognormal, to conform to actual stock market behavior.Now, if the market were to rise by the exact same percentage everyday, it turns out that its volatility—according to the mathematical formula—would be zero! This almost defies logic, for any trader can tellyou that if he is riding the back of stock that is galloping higher everyday—even if it’s by the same percentage each day—it most certainlyis volatile. But that’s the way that volatility is calculated.Relating this to stock market movements, then, can perhaps clarify some of the behavior we see in volatility. During bearish markets,the down days are usually fierce and the decline is swift. However,the market gets “oversold” quickly, and then there is usually a monster rally—just for a day or two—before the decline begins again.This combination of large declines and large advances produces a
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high volatility reading via the formula for calculating volatility. However, in rising markets, it is often the case that the market grindshigher—never really “melting up” but rather making a series of newhighs, with very subdued declines. In fact, that’s exactly what themarket was doing from March 2003 through February 2004; andyou can see from Figure 4.19 what happened to VXO during thattime: it collapsed from relatively high levels to eight-year lows.But, as stated earlier, if a rally develops some herky-jerky movements—say, several large up days followed by a sharp, but occasional, setback after the market gets overbought—then volatility canactually increase while the market rallies. This is what happened in1995, for example: the rally was long-lived, but there were shortlived, occasional setbacks that produced the volatile movementsneeded to make VXO increase over the time period of the rally.It’s not really important to know how to calculate volatility. Theimmediately preceding discussion was just presented to give thosewho want it some insight into the workings of the volatility calculation. One can certainly observe the trend of VXO, determinewhether it has made a low that has lasted for a month, say, and thentake appropriate action for the expected market explosion. Whenyou’re ready to trade this situation, the best approach—if you’reunsure as to the primary trend of the market—would just be to buystraddles, for they would be cheap when VXO and VIX are makinglows. Then sit back and wait for the market to explode—and hopefully for volatility to increase as well. Of course, if you have a goodfeel for what the primary trend of the market is, then you can gearyour option strategy toward the direction of that trend, rather thanmerely taking the more neutral approach of buying straddles.
A Case Study: The 1994 and1995 MarketsAs noted earlier, volatility was relatively low during this period, butthere were enough swings in VIX (which at the time related to OEXoptions) to produce several good trades over that period. ConsiderFigure 4.21. The graph shows the last few months of 1993, when
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Figure 4.21VOLATILITY INDEX—VIX
volatility began to trend lower. In fact, it broke below the year range,falling all the way to 9 percent in December 1993 (point A on thechart). In fact, this was the all-time low for VIX and remains the alltime low even now, over 10 years later.Figure 4.22 shows the chart of OEX for the same time period—1994 and 1995. The market was edging modestly higher and making incremental new highs through January and into the beginning ofFebruary 1994. Then the Federal Reserve System (the Fed) raisedrates for the first time in years, and OEX quickly fell nearly 50 pointsin just a couple of months—a sizeable decline of about 11 percent.So the low volatility on the VIX chart in December (point A) was a
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THE PREDICTIVE POWER OF OPTIONSFigure 4.22OEX
good warning sign for what eventually turned out to be a major market decline.All the while that this decline was taking place, OEX impliedvolatilities were rising. As the declines accelerated in late March andespecially on the first trading day of April, VIX shot up to nearly 22percent (point B on Figure 4.21). Implied volatility quickly retreatedfrom those extremely high levels, leaving a spike high on the chart.An extremely high implied volatility reading, especially if itoccurs as a spike, is generally a sign that a short-term bottom is athand for the broad market. OEX rallied right after that spike inimplied volatility, and the rally carried into the middle of June 1994.
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So the spike in implied volatility at the very beginning of April was agood time to buy the “market,” or OEX in particular.If you look back at the chart of the VIX, you will see that itreacted all the way back down to 11 percent while this market rally,which began in April, was going on. In June, a short, sharp marketdrop followed. By late June, this decline sent VIX spiking back up to17 percent. This was a very short-term movement, so many tradersmay not have caught it. However, with the aid of VIX, you wouldhave at least been aware that a trading high and low were likely.In the late summer of 1994, the broad market was rallying onceagain. As is customary during steady rallies, implied volatilityremained low, in the 11 percent to 12 percent range (point C in Figure 4.21). At about the same time that VIX broke out to highervolatility numbers over 12 percent, another relatively quick andsharp market decline began (in September). Once again, low volatility had preceded a falling market. Often, the timing of the marketmove, whether up or down, can be refined by noting when volatilitybegins to increase.Even though the broad market rallied a little in October 1994, iteventually made its way to a new low in early December. Impliedvolatility, as measured by VIX, climbed rather steadily during thatwhole time, once again reaching levels above 18 percent (point D inFigure 4.21). From there it spiked down, a buy signal. In fact, thisturned out to be a very large buy signal, as OEX and the broad marketembarked on one of the largest rallies in recent memory. So, during1994, using VIX as a guide to short-term market movements wasvery profitable.As the large rally that started in December 1994 worked its wayhigher over the next couple of months, VIX fell below 11 percentagain (in February 1995; point E in Figure 4.21). As it turned out thistime, the market roared even higher. This, then, is an example oflow volatility preceding an upward move in the market. After that,implied volatility settled into a trading range between 12 percent and15 percent, neither spiking too high nor reacting to a new low.In order to have profited from each of the low volatilities during1944 and 1945, you would have needed to buy straddles each time,for you did not know whether the market was going to move higher
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or lower. Since the moves were large, profit would have resulted.Backspreads would have worked as well, as we’ll see in Chapter 6.Prior to the CBOE’s initiating the VIX, there were other notableperiods of extremely high or low implied volatility in OEX optionspreceding important market turns. Some of the low volatility examples include both August 1983 and August 1984. Both times, themarket exploded higher shortly thereafter. Then, in 1987, OEXimplied volatility reached very low levels just after the market peaked,but before the crash. Thus, followers of option premium were longstraddles when the crash came.In September 1987, the market had made some attempts to retest the alltime highs made in August, but those attempts were unsuccessful. At aboutthis time, implied volatilities of OEX options and S&P 500 futures optionswere trading with an extremely low volatility.The December S&P 500 straddle could be purchased for 15 points,with the index at about 320. That was a very low level of volatility, considering that the market had been rather volatile while rising all during thatyear. In fact, no three-month trading range had been contained within a 15point-wide band since the middle of 1985 (i.e., for over two years). Mathematically speaking, statistics indicated that there was a 93 percent chancethat the market would move at least 15 points in three months.As it turned out, the market moved much more than that, of course,falling over 100 S&P points during the crash.
Another Case Study: 1997–1999We will conclude this section with one more example of VIX tradingopportunities. Figure 4.23 shows both VIX and OEX over a two-yearperiod: from the fall of 1997 through the fall of 1999. While themarket was still in the throes of the bull at this time, there werenumerous VIX trading opportunities presented. In Figure 4.23, thespike peaks in VIX— which are buy signals, when accompanied by arapidly declining market—are marked with “B” for buy. However,the low VIX readings are marked with “X,” for explosion, since wedon’t know at the time they occur whether they represent buying orselling opportunities in the market.
IMPLIED VOLATILITY CAN PREDICT A CHANGE OF TRENDFigure 4.23$VIX AND $OEX: 1997–199923.960 22.250 23.500
B
19991110
B
BB
BB
XX
X
X
X
49.00047.00045.00043.00041.00039.00037.00035.00033.00031.00029.00027.00025.00023.00021.00019.00017.000
97O N D J F M A M J J A S O N D J F M A M J J A S O 991998199972.530 71.550 72.080
19991110
X
BXB
X
XXB BB
B
97O N D J F M A M J J A S O N D J F M A M J J A S O 9919981999
74.00072.00070.00068.00066.00064.00062.00060.00058.00056.00054.00052.00050.00048.00046.00044.00042.000
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First, let’s consider the buy signals. The first one occurred inNovember 1999 (for the cause, see the next trading story). On Monday, October 27, the Dow Jones Industrial Averages (the Dow)locked “limit down” for the one and only time in its history. Theexchanges had installed trading limits in the wake of the crash of1987, but they had never been tested until this fateful day.* The limitat the time was 550 Dow points. When the decline reached thoseproportions in midafternoon, trading halted, and since there was noforthcoming rally, that’s where the market closed. In reality, though,traders knew that the market had farther to fall, and thus the pricesof puts were bid up rather astronomically (and calls were basheddown). Thus, implied volatility spiked, and VIX reached 40.The next morning, Tuesday, October 28, the market openeddown about 200 points; but then a major rally set in, and the Dowclosed up over 300 points—a positive intraday reversal of about 550points, from low to high. Initially, VIX spiked to 55 intraday, beforecollapsing to 30 on the close. That clearly was a spike peak in volatility. If one had been only an observer, he could still have bought atthis point— after clearly seeing that VIX had made a spike peak. TheDow rallied another 600 points over the next few weeks. In Figure4.23, you can see the clear spike peak in VIX (only closing prices areshown), and the subsequent rally in $OEX—from 407 to 441 intraday on that big “Turnaround Tuesday,” and then on to 475 in thenext few weeks.Thus, even if you only observed VIX’s close, you could havemade good profits over the next few weeks. Moreover, if you were*Many traders and investors were not happy that the NYSE had to shut down, intraday, because they felt that that only created more-massive selling pressure, whichwas released the next morning. However, it was clear from the crash of 1987 thatallowing selling to continue unabated—without people having a chance to take abreather and assess the true situation—was not a good idea. In the wake of the1997 “limit down” event, the limits have been raised considerably and are somewhat based on the volatility of the market. If they were to occur now, they wouldtake place in stages: first, a half-hour trading halt; then, if there is more selling, atwo-hour trading halt; and then, if that doesn’t stem the tide, a full trading halt forthe day. At the present time, the first halt (a half hour) would occur if the Dow fell1,000 points intraday, and the full trading halt would not occur until the Dowfell 2,800 points intraday (the Dow was at about 10,400 when those limits wereset). The limits are reset every three months, to keep them in line with current market price and volatility.
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watching intraday, you would have surely surmised that VIX hadmade a spike peak when it fell from its high of 55 to, say, 40—unchanged on the day. Purchases made at the time would have profited nicely by the end of that day and could have been held while theensuing rally unfolded.All through 1997, there had been a massive seller of naked index options.On the trading floor, he was known only as “The Sheikh.” His identity wasclosely guarded, but his trading was not. It was common knowledge that hewould sell hundreds or even thousands of out-of-the-money puts and callson OEX naked. He was never heard from after October 1997.One of the fallouts of the Dow locking down the limit in 1997 was theforced liquidation of a large hedge fund run by Victor Niederhoffer, an experienced trader who had been successful as an associate of supertraderGeorge Soros. In short, when the Dow locked limit down on Monday, October 27, Niederhoffer’s fund could not roll their short puts to anothermonth or strike since the market shut down intraday (other markets, such asthe CBOE, shut down, too, when the Dow reaches its limit—not just theNYSE). As a result, a massive margin call ensued, and a majority of thepositions were liquidated on the opening of trading on October 28. That’smainly what caused the spike peak in VIX that morning, sending it up to55. Margin clerks don’t bid for things, they just buy them at the market, forif a customer’s margin is completely exhausted, then the brokerage firm atwhich his positions are kept could be liable for any further losses.Was Niederhoffer “The Sheikh?” No one is saying for sure, but rumorson the trading floor were rampant that they were one and the same after itbecame public knowledge that Niederhoffer’s hedge fund was carrying suchlarge naked index put positions and had been forced to liquidate, while atthe same time “The Sheikh” had disappeared.
As it turns out, this wild action in the market was only preparation for a much more volatile period a year later—in 1998. On theVIX chart in Figure 4.23, you can see two buy signals— one on September 1, 1998, and one just over a month later, in October 1998.The first spike peak was caused by the Russian debt crisis that escalated out of control at about that time. The second was the a generalmarket panic, fueled in good part by the near failure of a massivehedge fund, Long-Term Capital (whose problems were related in nosmall part to the Russian debt crisis that had occurred the month
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before). These events sent the market careening downward twice,with VIX spiking up to very high readings each time. However, bothtimes the subsequent spike peak in volatility was a good buy signal—the first one lasting only a couple of weeks before selling set in again,but the second one being a true intermediate-term buy signal thatcarried OEX 180 points higher in just three months!After those two massive VIX readings, the other three spikepeaks shown in Figure 4.23 are somewhat subdued, but they weregood buy points nonetheless. They occurred in January 1998, January 1999, and October 1999. None were related to anything morethan somewhat panicky selling (no major news events). The last oneprobably occurred for no other reason than that traders were verynervous in October 1999, after the previous two Octobers. The OEXchart in Figure 4.23 shows that all three were good buy points, withOEX gaining substantially after each one.The low volatility readings in Figure 4.23 were nearly as plentiful. There were five of them. Each occurred with VIX somewherebetween 17 and 21 at the time. In real time, an investor might havenot been sure when the bottom in VIX was going to occur; but if oneused a gauge of, say, a VIX increase of three points from its bottom(from 17 to 20, for example) as his definition of a “VIX bottom,” hecould have profitably purchased straddles.Three of the five low VIX readings led to declining markets. Thefirst low reading occurred in early October 1997 and led to the nastydecline at the end of the month. A larger decline occurred in July1998 and marked the top of the market for several months (someeven call July to October 1998 a “mini bear market,” since the majorindices declined over 20 percent in that time period). Another,shorter-term selloff occurred after another low VIX reading in July1999.The other two low VIX readings actually occurred right in themiddle of strong market rallies—in March 1998 and in December1998. In both cases, the market continued on farther (even thoughVIX began to increase).Thus, index option implied volatility is not only useful as a marketindicator, but also as a strategy indicator. That is, when impliedvolatility is too low, option buying strategies are better, for a marketexplosion may be at hand. But when implied volatility is high, selling
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strategies may be good for strategists, whereas buying the marketmay be good for speculators.
The Seasonality of VolatilitySeasonality, a method of analysis applied to many aspects of themarket, merely describes market tendencies that seem to occur withsome regularity at fixed dates. For example, you might observe thatthe market often rises during the last couple of trading days eachmonth, as institutional “window dressing” takes place. A longer seasonal pattern is the market’s tendency to move in a four-year cycle,where the low point is reached in the year midway between presidential elections (2002, 1998, 1994, etc.).The point that you should realize is that a seasonal pattern is justan average of the movements over time of the market being studied.In any one year, the market in question might behave in a mannerquite contrary to what the annual seasonal chart indicates. Seasonality’s usefulness is often only realized if an investor has the ability totrade the same position or strategy several times in