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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Implied volatility is derived using an option valuation modelVIX AND VXN The Chicago Board Options Exchange created the CBOE Volatility Index, or VIX, in 1986. VIX has become the number one gauge of market volatility available today. Computed throughout the trading day, it is unique in that it offers up-to-the-minute or real-time information regarding market volatility. Therefore, there are no cumbersome calculations and the information is available at the click of the mouse. (For example, go to the Optionetics.com home page and enter $VIX in the quote box.) VIX gives up-to-the-minute readings of market volatility. At the same time, it is not a gauge of actual volatility, but a measure of implied volatility. Implied volatility is derived using an option valuation model. In the case of VIX, the options are on the S&P 500, or SPX index, which is an index of 500 large companies with stocks trading on the U.S. exchanges. Therefore, VIX represents the market consensus view regarding the future volatility of 500 of the largest and most actively traded stocks. So, as VIX measures the implied volatility of SPX options, it will begin to rise when traders expect volatility to increase. During times of uncertainty and market turmoil, VIX will move higher to reflect expectations regarding future volatility going forward. For that reason, it is often referred to as the fear gauge. However, during times of relative tranquility in the U.S. stock market, VIX will move lower to reflect investor expectations that market volatility will remain low. The chart shown in Figure 17.1 details the performance of VIX from 1999 to early 2004. During the fifth year, beginning in March 2003, the market performed well and stocks moved broadly higher. During that time, the CBOE Volatility Index edged lower. In fact, VIX fell to seven-year lows of 14.3 percent in early 2004. There was no fear reflected in the markets fear gauge. Another interesting aspect of the chart is the periodic spikes in the volatility index. This happens during periods of panic in the market. For instance, shortly after its inception, during the market crash in October 1987, VIX hit a record high of 173 percent, which has never been surpassed. In the mini-crash of 1989 after the problems associated with UAL and its restructuring, VIX spiked again. In 1990, when Iraq invaded Kuwait and the United States became embroiled in a war in the Middle East, the volatility index spiked twice: once when Iraq moved into Kuwait in 1990 and again in 1991 after the United Nations attacked Iraq. More recently, in October 1997, investors were spooked when the Dow Jones Industrial Average tumbled 555 points. VIX jumped to 55.5 percent. In the fall of 1998, as the impact of the global financial crisis was beginning to shake U.S. markets, market anxiety once again picked up. The volatility index soared above 65 percent in October 1998. On the chart, we can see VIX spiking again in September 2001 when the terrorist attacks rocked the financial center on Wall Street. Since that time, VIX has traded below 50 percent. In response to the growing interest in Nasdaq 100 options, the Chicago Board Options Exchange launched an implied volatility indicator on the Nasdaq 100 Index in January 2001. Known by its ticker symbol, VXN, the new implied volatility indicator was created to track the implied volatility of the popular NDX options contract. Like VIX, it is updated continually throughout the trading day. In addition, traders can also plot the indexs long-term movement in order to identify the extremes. As we can see from Figure 17.2, VXN has been in a long-term decline since its inception. However, there are times when it spikes higher, like in September 2001 and July 2002. A move higher in the Nasdaq volatility index tells us that the implied volatility of Nasdaq 100 Index options is on the rise. Therefore, traders are expecting market volatility to increase going forward, which generally occurs when investor anxiety levels and fear are on the rise. Using VIX and VXN as sentiment indicators requires a bit of contrary thinking. An adage among options traders says, When VIX is high, its time to buy. When VIX is low, its time to go. This tells us that when VIX is high, it is time to buy into the stock market with long strategies such as bull call spreads or other bullish strategies. During these times, market anxiety levels and pessimism are high. In that case, investors, or the crowd, have probably overreacted and driven stock prices to bargain basement levels. When VIX is low, it is time to go, or get out of the market. During those times, investors are probably complacent or too bullish on the stock market. So the contrarian thinker will get out of bullish positions, or even set up some bearish trades. A NOTE ON BEING A CONTRARIAN Taking action contrary to the crowd will always feel uncomfortable. At the actual time you must decide and act, you will never have all the information youll want because gauging market psychology is more of an art than a precise science. Furthermore, your countertrend decision will make you feel lonely, and we humans are social animals who seek comfort and approval from others. Always remain tight-lipped about your investment moves. If youre a talking contrarian, people hearing of your views and behavior will exert immense pressure and may convince you to abandon your thinking at precisely the wrong times. Successful trading, contrarian-style, requires observation, understanding, and, finally, action. First, you must see facts: events, trends, and rates of growth or decline. It is imperative that the contrarian trader develops a sense of history, an ability to put things together in context, and a good feel for when a trend is moving to an extreme. But even all that will do you no good if you dont take action. Acting is usually the most difficult skill to master. Being a contrarian requires that you identify the markets situation, whether that be broad averages or the market of opinion. The factual and emotional states of the economy and the market can be observed at any time. Successful investment behavior requires patience so that you dont pull the trigger at the very first observation of important elements; you need to wait for an accumulation of evidence that an extreme is developing. Trying to play contrarian on a short-term basis creates what is known on the street as whipsawed traders. Given that the public is usually right during the trends but wrong at both ends, we should not get impatient at the first sign of extreme behavior in others. Let a trend run for a while and watch the evidence accumulate. This approach can be profitable due to the bipolar nature of market dynamics. The trick is to recognize a markets turning points by monitoring psychological market indicators to assess your next move and then trade with or against the majoritys view of the market. One indicator alone, like VIX, will not necessarily help you time the turning points. To invest contrary to the crowd, you need to consider a broad range of indicators, the big picture, and sometimes exercise a great deal of patience. NONANALYTICAL METHODS There are many other ways to find a good investment. However, the two most common are probably the most unreliable. It is important that you use discretion as you make investment decisions. Reliance on Others The biggest mistake most people make in the field of investing is relying on others. This includes consulting brokers, listening to friends, receiving tips, or even calling psychic hotlines. Professional money managers (mutual fund managers) also must be selected with care. Be careful whom you listen to. You are the only person who is ultimately responsible for your own profitability. Make a strong commitment to relying on your own initiative. Religious Experience From long observation, it seems to me that prayer is truly the method most often used by traders and investors. Most traders and investors do very little analysis and have no idea as to what is going on; still they go ahead and trade. Then, they just pray that they will be right. Even when their initial position goes against them, they just stay in the bad trade praying the market will come back. They continue to pray until they cant take the loss anymore or they lose all their money. Nick Leeson, the trader who allegedly lost $1 billion for Barings Banka loss that brought down the 200-year-old institutiongot himself into a bad position and kept adding to that bad position praying that the market would indeed turn around and make him right. It never happened. Seize the day! |
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