Don’t Get Skewed
The VIX’s primary shortcoming is that it only provides a 30-day snapshot of fear and greed.
To increase the accuracy of volatility analysis requires looking deeper in the market. The key message for determining if the stock market will rise or fall is “skew.” That odd little word describes the implied volatility of put and call options that will increase in value if a stock index makes a sharp move higher or lower.
Remember, put options increase in value when stock prices decline. Call options do the exact opposite. Calls increase in value when stock prices rise.
When sophisticated investors fear the stock market will decline, they tend to buy bearish puts that will increase in value if, say, the Standard & Poor’s 500 Index declines. To save money, sophisticated investors tend to buy puts that will increase in value if the stock market declines by 10 percent. Because declines are not always one-day affairs, sophisticated investors tend to buy options that expire in three months so that they can maximize protection. Knowing this quirk of sophisticated investors lets other investors monitor the hidden crash protection market. The key is comparing the implied volatility of bullish calls and bearish puts. If the put volatility is at 37 percent, and call volatility is at 20 percent, it is a sign that the options market is preparing for the stock market to decline. That conclusion is evident because volatility—which is concerned with how likely a stock, or index price, ...