Stock markets worldwide have been making the news these last few weeks. Lead by the massive plunges in the Chinese stock market, markets across Europe, Asia the US and Australia have suffered heavy losses. And on Monday the ASX had its biggest decline since the GFC.
$60 Billion was wiped off the Stock market on Monday alone.
This came on the back of losses in the previous week. However, it wasn’t all bad news, as this sudden drop was followed by a strong recovery on Tuesday and milder to mixed returns for the rest of the week.
Much of the volatility around the ASX200 and world markets more generally, is around concerns on the health of the Chinese Economy, and how overvalued their share market is.
Turbulent times make predicting the movement of a share market difficult and there are many different investment and trading strategies that people employ.
For instance, real money investors may not have wanted to “catch a falling knife” and possibly waited for markets to begin to plateau out before investing. Others like hedge funds would employ different strategies to take advantage of the increased volatility. Some investors can buy the volatility itself by either trading options or trading the VIX.
The VIX is just a measure of the volatility of the S&P500, and there are other volatility measures for other markets too. The VIX is commonly known as the “fear index”, and last week it lived up to its nickname.
The VIX it is a mathematical measure of how much the market thinks the S&P 100 Index option, or OEX, will fluctuate over the next 12 months, based upon an analysis of the difference between current put and call option prices.
The VIX index roughly correlates to a percentage, so a VIX of 22 represents a volatility of around 22% on the markets. This suggests that it is likely that stocks will trade within a range 22% higher than or lower than its current level, over the next year.
Some analysts would argue that we are in a bullish market if the VIX is low, and a bearish market if it is high (showing the “fear”). Anything above 40 is considered an event such as:
The VIX is traded on the Chicago Board of Exchange, which means it’s probably out of reach for most non-institutional investors. Its cousin – the option, may seem a more practical trade.
There are two types of Options – Call Options and Put Options. Both can be bought or sold, or used in combinations to create strategies suited to your risk tolerance. Options positions should be looked at from both the standpoint of the BUYER (or taker) and the SELLER (or writer).
This article won’t go into too much detail here on option mechanics, but we can say that options are generally used to profit from a directional trade.
For instance, if you think CBA shares will rise in the next month, you might purchase a call option with 1 month expiry. How CBA’s price will get there and the probability of it doing so within the time horizon, is a function of volatility.
Option traders will tell you to buy options when cheap, and sell or write when expensive. Simple enough? There are a myriad of other strategies that can be put into play to extract income and the like – but we’ll save those for another week.
Looking back at the VIX example, and considering events over 40 are reasonably extreme, bold traders may have shorted the volatility index over 40, and rode a white knuckle ride back down to its current level of 26 to make a handsome profit. Not bad for a week’s work?
