Volatility, Complacency, and Fear
In financial markets, volatility means price movement.
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Your stock market portfolio has been doing well. Its value has been steadily increasing. Over the next month, stock markets decline precipitously and your portfolio's value decreases 15%. Fear has replaced complacency, as you're suddenly concerned about managing risk and minimizing further losses. This human reaction to price volatility is one that savvy market participants recognize.
Effective market participants are aware of the concept of volatility and how it influences financial markets.
Sentimental Journal of Volatility
MV professors frequently discuss market volatility. Volatility (or just 'vol') refers to price movement. Vol comes in two flavors. Historical vol reflects past movement in a security's price (often expressed in terms of standard deviation). There is also implied vol, which represents market participants' estimate of future movement of prices derived from option prices.
Implied vols are useful because they represent a forecast of anticipated future movement in prices. Market participants pay more for options when they think prices will move a lot. As a general rule, low volatility and extreme option selling reflect complacency; high vols and extreme option buying reflect fear.
Popular measures of market volatility include the VIX and VXO which both reflect implied vol in S&P index options. Volatility indices like these are often used to gauge collective market sentiment.
Jekyll & Hyde
The charts below show the S&P 500 Index (SPX) and a popular measure of S&P index volatility during a multiyear period.
Charts courtesy of StockCharts.com
Note that when the SPX declined significantly, the VIX increased significantly. During periods of rapidly declining stock prices, market participants tend to pay high prices for put options to hedge against further downside risk in their portfolios. As buyers pay more for these put options, their implied volatilities move higher which, in turn, pushes up the value of the VIX.
It might seem strange that market participants wait until after a big decline before paying for 'protection' against loss. After all, the cost of these options would have been much lower had market participants purchased these 'insurance policies' ahead of time. While perhaps irrational, willingness to pay big option premiums after price declines is a classic behavioral reaction to risk that has been realized (Kahneman & Tversky, 1979).
Measuring 'What Is'
This is why measures of implied volatility do a decent job of capturing collective feelings of complacency and fear in the marketplace.
Note, however, that because of the reactive nature of market participants to big price movements, volatility indices such as the VIX and VXO contain relatively little predictive information. They tend to reflect what 'is' rather than what 'will be.' Rather than forecasting tools, volatility indices tend to be more useful as coincident indicators.
Kahneman, D. & Tversky, A. (1979). An analysis of decision under risk. Econometrica, 47: 263-292.
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