From the July/August 2013 issue of Futures Magazine • Subscribe!

How to leverage fear with confidence

Implied volatility, VIX, fear

Understanding that emotions tend to drive markets to extremes, you’ll want a means to measure those extremes to gain an edge when and where the market is likely to reverse itself. An effective tool for doing this is implied volatility (IV).

IV is the estimated volatility of a security’s price. In general, it increases when the market is bearish and decreases when it is bullish. This is because of the common belief that bearish markets are more risky than bullish ones.

As one of the largest and most-followed indexes, the S&P 500 is a good subject for your IV analysis. The Chicago Board Options Exchange (CBOE) Volatility Index, or VIX, measures the market’s expectations for 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk. (“Fear gauge,” below, charts the VIX.)

To understand how you can trade with this knowledge, re-consider the revelations of the Dalbar study, that investors usually do the wrong thing at the wrong time when fear and greed are in play. When these emotions drive the market, price moves are not based on sound valuations. In the long run, emotions often are wrong, which is why price typically snaps back when it’s driven to extreme levels.

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