Can you calculate fear? Certain market measures help traders determine when the market seems “fearful.” Learn to do this for yourself to better evaluate risk.
Fear is as much a part of modern trading as macroeconomics. But don’t let those fears haunt your trading dreams. Two lesser-known market measures can help self-directed traders get a deeper understanding of risk and what makes the market jumpy.
You can’t trade a gauge or index or “feeling.” But you can keep an eye on these barometers and grow your awareness of potentially extreme market moves. Because options markets are often driven by fear, learning to spot those clues could elevate your trader status and possibly improve results. Institutions routinely use VVIX and SKEW, mostly for tail-risk hedging strategies. You can, too. Let’s take a deeper dive.
The CBOE Volatility Index (VIX)—commonly referred to as the “fear gauge”—is driven by SPX options prices. But what about the VVIX index, which takes the VIX to a deeper level and analyzes, in some sense, the “fear of fear?” The CBOE uses the same methods in both indices, but there’s one crucial difference. The VIX is based on SPX options, while the VVIX is based on out-of-the-money (OTM) VIX put options.
Punch in the symbol VVIX on your thinkorswim® from TD Ameritrade platform. Consider the long-term chart to see VVIX’s range and the average value of that range. Where does the VVIX’s value stand with respect to that average?
In short, the logic of the VVIX is based on volatility. When vol is high, you might expect greater implied-vol fluctuations. As a result, the market could bid up options on vol products. If you see a relatively high VVIX, this suggests there may be a premium to sell in VIX options.
Don’t confuse this with the “skew” that means tilt in a normal distribution curve. The CBOE SKEW Index, also called the “black swan” index, measures the probability of outlier events, or down moves, of two to three standard deviations. The SKEW’s value typically ranges from 100 to 150, although it’s been known to go lower and higher. When it’s at or close to 100, the possibility of a black-swan event is unlikely. The market in these moments is complacent. When the SKEW is at 115, it suggests a 6% risk of a black-swan event occurring. If SKEW is at 135, that risk can rise to 12%.
You see how risk often doubles when the SKEW moves from 115 to 135. To put some context around current market risk, type the symbol SKEW into your thinkorswim platform. Pull up a chart and look back over a two- to five-year period. You’ll see that SKEW hit a high of 153.66 on June 27, 2016, in response to the Brexit vote. What can a high SKEW mean for your portfolio? It signals that OTM puts are being bid up. And if OTM puts are trading high, that could signal a potential opportunity to sell puts.
Despite all the fancy science wrapped around trading, market fluctuations are often driven by emotion. If you have a feel for what those emotions are at certain critical inflection points, consider yourself a market participant who’s paying attention.
Above all, stay vigilant. If you’re watching SKEW and VVIX in relation to your own strategies, you may be ahead of the fear game. So go ahead, talk up VVIX and SKEW at your next shindig—you’ll be all the rage.
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Jayanthi Gopalakrishnan is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.
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