A trader can look to the put/call ratio of any stock to ascertain the expected price movement of that stock. Although not fool proof, this indicator is helpful in gauging directional movement of a stock, especially when the volume suddenly spikes. The higher and quicker the volume rises, the more traders believe the price will move in the “expected” direction. Keep your eyes open and look for the “action” in the options market. In fact, CNBC has a show called “Options Action,” which just might help you both understand and utilize this indicator.
Generally, though, you can look to implied volatility to ascertain future market direction. Implied volatility measures how much the market thinks a stock’s value will change – in either direction – in the future. A trader can calculate implied volatility independently, or a trader can simply look at the VIX, the volatility index that measures the implied volatility of the stocks on the S&P 500. The VIX continuously calculates implied volatility on a forward-looking, 30-day basis. Simply, the VIX measures the expected directional movement for the S&P 500 for the coming thirty days.
Keep in mind markets are always seeking equilibrium. When the market prices in the S&P 500 are bouncing around, the VIX will run higher. This indicates uncertainty in the views of the market participants. When the VIX heads lower, it generally means market participants are more in agreement about the future direction of the markets. When the VIX spikes suddenly, this indicates something has “spooked” the market participants, and fear has now moved into play. This is why the VIX is also referred to as the “fear index.” When the VIX does spike, it is your job to understand why.
One more thing you should consider about the VIX. When the index remains low and relatively stable for some period of time (low is below 25), it can mean the market participants are waiting, waiting for something to happen. In this state, market participants are edgy. Any piece of news can and will move the markets suddenly. In fact, the best example I can give you is the current state of the VIX. It has remained below 20 for some time now, and we have recently seen how news (good or bad) can push the market up or down in a day. This is ideal for intraday and day traders, as market participants often see this environment as an opportunity to sell.
Finally, since the VIX itself can be volatile, so you might consider plotting the actual VIX against a moving average of the VIX. This will smooth out the spikes and give you a deviation to measure potential market direction and potential trends.
The VIX is not the only volatility index available to you. The Nasdaq 100 (VXN), the Russell 2000 (RVX), and the Dow Jones (VXD) all offer volatility indexes. As well, several European indexes offer volatility indexes.
This cursory view of implied volatility as an indicator should spur you to at least consider adding this indicator to your toolbox. If it interests you, there is a whole bunch more to learn about implied volatility, and a lot more ways you can use it.
Trade in the day; invest in your life …
