I came across this chart over the weekend. It looks at the volatility of stock, bond and currencies markets. The article that accompanies it falls into a trap I have commented on before namely, that volatility and changes in volatility are predictive. My view is that they are post-dictive – that is they react after the event. If you are lucky they are concurrent with an event. This is not rocket science once you understand how the VIX is constructed. The VIX is the implied volatility of S&P500 options, if you take the options pricing equation and solve for volatility you get the implied volatility of the option. This is the volatility that is implied by the current option price. If you look at option pricing there are five inputs of which three could be considered prime drivers.
These drivers are the price of the underlying, time to expiry and volatility. Everyone is familiar with the price of the underlying and time to expiry. options are a wasting asset, once they are gone they are gone. However, volatility is a difficult for traders to grasp and therefore it is difficult for them to grasp the implications of changes in volatility on an assets price. Part of the difficulty with volatility is that it is not directly observable – it has to be measured some way and this measurement has to be interpreted.
Once the underlying asset begins to swing in value then option market makers will demand greater compensation for the risks they are incurring in offering options for trade. The article offers up the idea that complacency is a bad thing and that there are a host of macro economic reasons as to why this might be so. To my way of thinking a measure of the market is neither good nor bad – it is simply a number or a series of numbers represented on a chart. Complacency is neither bad nor good – it is simply the state of the market.
The other point I take some issue with is that periods of low volatility are naturally followed by periods of high volatility and this implies a crash. Volatility will mean revert – that is it will swing around a mean value. this is why option traders use volatility to determine whether an option is poorly priced and attempt to take advantage of it. The relationship between volatility and an options price is linear, so if volatility doubles the price of the option should double. Low volatility does not imply that a crash is coming, it simply means that traders see no reason to move their pricing matrices to a new point.
The central issue is whether volatility is in some way predictive of the future to which my answer would be no. a predictive tool is one that moves before a change in asset prices not concurrent with or after and asset price moves. It should be remembered that option traders have no special super psychic ability – they no more have any idea of the future than any once else does. As such they are reactive entities – they are not imbued with any ability that any other trader who is perceptive and disciplined doesn’t possess.
