BASIC TECHNIQUES
Forecasting Trends With Indexes
Using Implied Volatility And Volume
by Scott Castleman
Construct a trend-following system that adjusts to current market
conditions.
Traditionally, technicians have relied on
historical prices to analyze the market. They have created many different
indicators to predict the direction of prices by basing their calculations
on past data. However, these indicators may fail to work prospectively
when markets do not repeat their historical patterns. Thus, using these
indicators to forecast market direction is like trying to drive a car by
looking in the rearview mirror. Any change in the road ahead could lead
to disaster.
When we are searching for ways to forecast the direction of the market,
it is essential to characterize the market with current information. Two
such ways of describing the market are with implied volatility and volume.
Using implied volatility and volume as parameters, you should be able to
construct a profitable trend-following system by adjusting the number of
days referenced in a simple Donchian-style breakout system. This
allows the system to adjust itself to reflect current market conditions.
IMPLIED VOLATILITY
The implied volatility is volatility that the market is currently anticipating
for the underlying asset, which can be a futures contract, a stock, or
an exchange-traded fund (ETF). Implied volatility is usually used
for trading options on the underlying, but you can also use it to trade
the underlying itself. Calculating volatility can be a problem, because
you are trying to measure something that will occur in the future. Implied
volatility is based on an expectation as opposed to a posted value, but
it is a necessary component of any option pricing model.
FIGURE 1: THE S&P 100 INDEX (OEX) VERSUS THE IMPLIED VOLATILITY
INDEX OF THE S&P 100 OPTIONS (VIX). The top price chart is the
S&P 100 index (OEX), and the bottom price chart is the implied volatility
index of the S&P 100 options (VIX). The red up arrows indicate high
levels of the VIX, while the blue down arrows indicate low levels. The
high VIX levels reached in September 2001, July 2002, and October 2002
are associated with market bottoms. Low VIX levels reached in July 2001,
March 2002, and August 2002 are associated with market tops.
...Continued in the June 2003 issue of Technical Analysis of
STOCKS & COMMODITIES
Excerpted from an article originally published in the June 2003 issue
of Technical Analysis of STOCKS & COMMODITIES magazine. All rights
reserved. © Copyright 2003, Technical Analysis, Inc.
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