Back in June, I wrote about the effects of pricing uncertainty on shares.
To recap: greater uncertainty tends to drive sharemarkets lower, since future cash flows become more unpredictable.
But uncertainty also drives options higher, since volatility increases their chance of winding up 'in the money' when they expire.
One of the most important global measures of volatility is the VIX index, sometimes known as the 'fear index'.
And now Australia has its very own fear index – the S&P/ASX 200 VIX – launched by the ASX and Standard & Poor's on 22 September, with the ASX code XVI.
The Aussie VIX, or XVI, is a valuable addition to your investment toolbox, potentially giving you advance warning of large fluctuations in the ASX 200 up to 30 days ahead.
Uncertainty tends to drive option prices higher, since they benefit from greater volatility. In fact, option pricing models, such as the widely used Black–Scholes model, use volatility as a key variable in calculating the fair market price for a given option series.
The XVI is based on the same principle. By taking actual prices for index options over the S&P/ASX 200, then plugging them into the option pricing equation, the index gives a reading of implied volatility – the level of volatility that options traders have priced in to the market. By using options with the right expiry date, the index gives us a reading on forecast volatility for 30 days in the future.
The advantage of this approach is that it is based on real options trades with real money, rather than analyst predictions. As we all know, putting money at risk tends to concentrate the mind, so we can be confident that the index reflects traders' best guess at future market movements. It's also a well-established principle that the collective wisdom of markets can provide greater predictive power than the forecasts of individuals.
The disadvantage is that Australia's index options market remains relatively small and illiquid, potentially limiting the accuracy of the forecasts it generates. More importantly, bond traders are often as surprised as the rest of us by the overseas shocks that have recently been shaking our sharemarket.
Reading the Aussie XVI is simple: the higher the index, the higher the predicted level of market volatility. Importantly, indices of this kind have a tendency to 'revert to mean', so that they tend to return to their long-term average over time. As a result, any level above the long-term mean indicates more fear and more volatility; a level below the mean indicates less.
The graph below compares the performance of the Aussie XVI to the ASX 200, using historical data calculated for the release of the index. As you can see, it has anticipated significant movements in the ASX 200 fairly consistently, although not with perfect accuracy. For example, the jump in the XVI from late August 2008 would have provided a handy forewarning of the market carnage to come.
The Australian XVI (above, ASX code: XVI) versus the ASX 200 (below, ASX code: XJO)
One final word on the importance of fear in the current market.
While the world has always been an uncertain place, a globalised financial system has made overseas shocks increasingly important for Australian shares – and not only events in the US, the traditional pacesetter for our market.
Recently, we've seen the Australian market shaken by events which you might think would have little impact on the fundamentals of our companies and our economy, from the Irish debt crisis to tensions on the Korean peninsular. That's because of a repeated pattern in which overseas investors, spooked by negative sentiment, shift money out of stocks, commodities and risk currencies (including the Australian dollar) and back into the US dollar. Then, when their fears subside, the pattern reverses, sending money back into commodities and the sharemarket.
This pattern is likely to remain in play until local news, such as strong regional growth or improving company results, takes priority. Until then, overseas volatility will continue shake and move our sharemarket – and fear will remain a key factor in day-to-day market movements.
Happy trading!
Julia Lee Equities Analyst Bell Direct Have you started trading with Bell Direct for just $15 a trade? Register now for free.