How to Use Volatility to Determine a Market’s Risk
A successful trader looks at the marketplace and evaluates his exposure to risk before making any trading moves. To do this, it is important to assess market volatility and understand the different factors that influence prices. At my educational company, Larry Levin Trading Advantage, we have compiled a list of indicators and market influences that will help you manage risk, give you an idea of trader mentality and prepare you for your daily trading activity.
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Asking the Audience
You know that part in Who Wants to Be a Millionaire where the contestant surveys the audience for an answer? Well, just like that gives you a feel for what a variety of people think, so does the Chicago Board Options Exchange’s Volatility Index (VIX). This index measures the market’s implied risk and in turn, the market’s volatility. The VIX, also known as the ‘fear gauge’, enables insight into how traders feel about certain market influences and conditions.
The VIX is based on the S&P 500 Index. When the VIX rises, the S&P 500 usually falls and vice-versa. The VIX can also help you determine if we are in a bull or bear market. If the VIX is experiencing a downturn, we are most likely in a bull market but if it is on the rise, we are probably in a bear market.
For example, on January 15th, 2010, the VIX traded at 17.91 and indicated a bull market. However, the calm did not last long because on January 22nd, the VIX jumped to 27.31, which showed signs of bearish conditions and panicked the marketplace. Was there a reason for the panic? Yes but more on that in a minute.
Political Moves, Regulatory Initiatives and Current Events – Oh My!
There are many factors that influence market volatility and in turn, the VIX. For example, political moves, regulatory initiatives and current events will play a huge role in the price movement of a stock or derivatives contract.
Using the example above, President Obama announced plans to reform the banking industry and curb trading risk on January 21st, 2010. The VIX closed at 22.27 on that day indicating that traders were pessimistic about the news and its influence on the market. On January 22nd, when the VIX hit a high of 27.31, it emphasized the fear and uncertainty in the marketplace. Looking at the prices and where the VIX is trading will give you insight into how headline news influences price movement and how traders feel about current events.
Guilty By Association
Individual stock prices also influence their sector’s volatility because the markets believe you are ‘guilty by association’. If one stock in a certain sector performs poorly, another stock affiliated with that sector might be impacted and cause volatility in the market place.
For example, hypothetically let’s look at Stock A and Stock B in the health care sector. Let’s say that the CEO of Stock A is retiring and the headlines report Stock A’s change in management. The news may not only influence the price of Stock A but Stock B as well because they are both in the health care sector. When evaluating risk, it is important to look at the big picture and assess an entire sector’s price movements. Remember that one stock may have influence on affiliated stock prices.
Do you know TED?
Liquidity also plays a large factor in the market’s volatility. Liquidity is the degree in which an asset or security can be bought or sold without affecting the asset’s price. Liquid markets see a high level of trading activity but when the markets are illiquid, the prices seem to fluctuate causing volatility. This is especially the case in the smaller markets. A large sell off in a smaller market will have a big impact on the price because of the lack of liquidity.
To measure liquidity, you can look at the TED spread or the difference between interest rates on interbank loans and short-term U.S. government debt, also known as T-Bills. The acronym is formed from the T in T-Bill and ED, which stands for Eurodollar futures contracts. A rising TED spread often indicates that liquidity is being withdrawn from the market and a sign of possible volatility to come.
Evaluating the market’s reaction to current events, it’s affiliation with moving stock prices and the amount of liquidity in the market will help you better understand what influences the VIX and help you manage your risk. When you follow price movements, try to determine if there are outside factors affecting the markets. What influences are they? How was the price affected? Once you understand how the market is influenced, you can determine your exposure to risk.
Larry Levin trades the S&P 500 at the Chicago Board of Trade, now known as The CME Group; the world’s largest and most diverse financial exchange. Levin is the Founder of Trading Advantage.com, a leading trading education firm specializing in empowering traders to achieve and surpass their financial goals. He appears regularly on CNBC, Fox Business News and other major media outlets worldwide.