Volatility can be a double-edged sword, providing quick gains if you nail the directional view and timing, but sting quickly if you’re on the wrong side. However, volatility can be harvested using options during volatile times, and additionally provide insights into the market’s view of the future. In this post we will explore how the use of implied volatility can be utilized by traders to gain insights into the market.
What is volatility?
Volatility is a term used to describe the magnitude of price movements in assets over a particular period. During times of low volatility, markets tend to be calmer with a lower magnitude of daily fluctuations, where the price of an asset does not move much. During times of high volatility, there are more drastic price fluctuations in an asset.
What is Implied Volatility?
Implied volatility allows investors to measure the future expected price fluctuations of an asset, an important indicator for options traders. The future expected volatility of an asset can be derived from the price of an option. Options pricing models use several components to derive the theoretical price of an option. Volatility plays the integral part of finding the theoretical price of an option. Because the price of listed options is determined in the open market; and by rearranging the option pricing models, it is possible to back out the implied volatility of an asset from the option’s price. This gives an indication as to the expected magnitude (not direction) of price movements until the expiration date of that option. When implied volatility is high and a large move is expected, options prices are more expensive and implied volatility is lower when options prices are cheap.
What drives volatility?
There are many things that can impact volatility, and these are largely fundamental or macro events. Key economic data releases, changes to monetary policy, natural disasters and even pandemics can increase volatility across the board for equities and sectors. Earnings announcements can also impact volatility for individual companies. Because earnings announcements are generally followed by a quick, large move in share price, there is generally a high level of implied volatility before the announcement.
How can volatility be used to navigate markets?
It is important to note that volatility is a measure of magnitude in price fluctuations and not direction. However, there is strong evidence of how changes in volatility can be used to predict future price movements in equities. Generally, there is an inverse relationship between volatility and equity prices, especially when volatility climbs to elevated levels. By using a volatility index, such as the Nasdaq-100 Volatility Index (VOLQ), investors can measure the 30 Day “At-the-Money” (ATM) implied volatility of the Nasdaq-100 to look for potential opportunities in the Nasdaq-100 Index (NDX).
Due to the inverse relationship, an increase in volatility usually is corresponded with a decline in the index value. This also is an indication of elevated fear and uncertainty in markets. When volatility declines from elevated levels, stock prices tend to rebound higher. Additionally, history has shown that spikes in volatility are usually short lived. When there is fear and uncertainty in markets, it is common to see a strong, but quick, equity decline. Thus, investors tend to use volatility indexes, like VOLQ, as a contrarian indicator to time a potential market bottom based on the assumption that volatility is not sustainable at elevated levels.
The chart above shows the Nasdaq-100 from April 2019 to May 2022. This highlights the areas where the VOLQ spiked and where the NDX experienced a reversal. There are a few observations that can be made from this chart. Firstly, spikes in the VOLQ are accurate in timing price reversals as shown by the red circles. However, this does not necessarily mean that these represent market bottoms. The blue circle in September 2020 shows that despite a spike and reversal in volatility, the NDX managed to move slightly lower soon after. Another example of VOLQ spikes indicating short-term reversal points rather than market bottoms is in 2022 where the trend has turned bearish and spikes in volatility reversed into short-term relief rallies and eventually continuing lower.
Can volatility provide insights into the direction of the markets?
The answer is a resounding yes, and the insights appear during some of the most volatile and uncertain times in the market. Typically, when a market is in a volatile selloff, investors start panic selling to raise capital, avoid margin calls and prevent further losses. It is during this panic selling mode that volatility indicators provide some of the most important insights. Observe the Feb to March 2020 COVID-19 initial selloff where the markets shed nearly a third of its value in just over one month.
As the Nasdaq-100 sold off heavily, volatility spiked as expected. But as most investors were asking, when will this selloff end, we saw the VOLQ index peak on March 16. However, it took the market a week further, on March 23 to bottom. This was a full week of a warning signal that we were near a market bottom as volatility declined alongside equity prices, before rallying sharply.
We see multiple examples of this during market stress in 2022 as the Fed starts to raise interest rates to battle inflationary pressures. In early March, as equity prices formed a triple bottom, volatility confirmed a temporary market bottom before rallying 15% in 2 weeks. And currently, we find ourselves with a bottoming signal from VOLQ, as markets have shed over 30% since November 2021. It is in my view that volatility has provided a signal that we have once again reached a temporary market bottom on May 20, 2022.
Summary
The evidence shows that despite volatility as an indicator of magnitude and not direction, there is information embedded within volatility that can provide strong directional insights during times of market distress. Spikes in volatility indices, like VOLQ, can be an excellent market timing tool during “normal” times. While the volatility of volatility can be an important tool in helping investors navigate markets during times of extreme distress for picking market bottoms. Lastly, this type of analysis should always be incorporated in conjunction with an understanding of the macro market environment to differentiate between a short-term reversal and a true market bottom.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.