Option Volatility: Contrarian Indicator

Implied volatility (IV) can be used as a gauge of how extreme investor moods have become. Like other measures of market sentiment, it can help to anticipate major market turning points. In this chapter, we’ll present some examples of how IV levels relate to past and future price moves. We’ll use the CBOE Volatility Index (VIX) for this process.

VIX was introduced in 1993, and since then it has become one of the most popular ways of determining investor sentiment and volatility in the stock market. It is a measure of implied volatility, capturing the market’s expectation of 30-day volatility implied by the near-term options on the S&P 500 index. (For more on this, see Volatility - The Birth Of A New Asset Class.)

In the examples in this chapter, we’ve used weekly close prices. However, higher frequency analysis can be applied as well. That is to say, VIX or IV levels on stocks can also be tracked for shorter time frames, and even intraday. Regardless, these levels can be used to identify short-term oversold and overbought conditions, and in each of these cases, reversions to a short-term mean of IV often occur. Thus, applying a contrarian approach provides investors the potential to yield above-average returns.

IV as a Measure of the Investor Crowd

The VIX index is popular as a gauge of investor moods, and it can swing wildly with high frequency. Put simply, it measures how expensive the options on the S&P 500 index are. Historical data is available for comparison on the Chicago Board Options Exchange (CBOE).

Figure 1 indicates VIX implied volatility between 1990 and 2006. There are extreme spikes above 40 during the lowest periods of the bear market (in 2000-2002). As investors become more fearful, VIX rises dramatically.

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Figure 1: VIX implied volatility index between 1990 and 2006. Note the extreme spikes above 40 during the worst periods of the bear market during 2000-2002. VIX rises sharply as investor fear intensifies.

Investor fear is linked with bearish markets and a rise in VIX. As fear recedes, VIX falls as well. Still, long-term low levels of the VIX have been associated with bull markets, and VIX levels which are extremely low may signal a major market advance. This is represented in Figure 2. In 1994 and 2004, VIX remained below 20 as the market developed significant bullish tendencies. (To learn more, read Getting a VIX On Market Direction.

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Figure 2: S&P 500 alongside levels of VIX. Here it is possible to see how price and volatility relate to each other. Typical of most big cap stocks that mimic the market, when price declines, volatility (VIX in this case) rises and vice versa.

VIX tends to react to sharp drops in the S&P, as we can see in the figure above. During major market meltdowns (1997, 1998, 2001, 2002), VIX increased sharply. This indicated that a market bottom was approaching. Because options have traded since the 1980s and VIX was created roughly a decade later, it’s also possible to back-build the VIX index, and the CBOE has a complete downloadable history. During the 1987 market crash, for example, the VIX increased to levels above 100. It even hit an intraday high of 172.79 on October 20, 1987 (this was based on S&P 100 options, not S&P 500 options). VIX has since changed its methodology to use S&P 500 options instead of S&P 100 options.

VIX is best viewed with moving averages, because it has a long-term trend cycle. Figure 3 presents VIX with moving averages spanning from 10- to 50-day levels. This allows us to better spot short-term extreme levels, suggesting that markets are overbought or oversold.

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Figure 3: Daily VIX and S&P 500 price charts. When the VIX 10-day moving average moves too far away from the 50-day moving average, the S&P 500 typically experiences a correction, as indicated by the small black arrows.

As we can see in Figure 3, spikes of VIX are smoothed with a 10-day moving average. As the 10-day moving averages climbs higher than the 50-day moving averages, market conditions become bearish. When the 10-day moving average goes below the 50-day moving average, market conditions are bullish. However, when the deviation of the 10- and 50-day averages are stretched, a reversion to the mean tends to occur as the 10-day moving average goes back to the level of the 50-day average. The way that this cycle works is a means for timing market swings as a contrarian indicator.

The Bottom Line

In this chapter, we explored how VIX implied volatility for S&P 500 index options can be used to identify overbought and oversold portions of the index. We saw how the two indexes (that is, VIX and S&P 500) move inversely to one another, and that one can use a contrarian method by applying different moving averages to daily VIX prices.