Can SPX Implied Volatility Be a Leading Indicator?


I came to an interesting revelation the other day during the AM Pit Report.  I was looking at a chart of volatility discussing why I thought the market might stay put when an option mentoring student said to me: "You know what Mark, you do like technical analysis, just not using the stock price!"  Low and behold the student was right, I do use volatility analysis, often, I like looking at skew, I like watching ATM IV, and I love analyzing term structure.  There is a reason for this, there is evidence that it actually does work.  In light of this revelation I thought I might show an example of the type of volatility analysis I do.

Below is a 6 month chart from Live vol.  On the top is the daily candle price.  Below that is a chart of 30 day implied volatility relative to 60 day implied volatility (30 days is red, 60 days is yellow):


I took the time to point out a few 'high volatility' events that have happened over the last 6 months.  What do you option traders notice?  When the 30 day IV gets higher, or equal to 60 day implied volatility it symbolizes a peak in panic.  It also symbolizes a bottom in the market.  Once the panic ends, as the market recovers, the two quickly separate.  Usually 30 day IV’s fall much faster than 60 day implied volatility (notice the green circles).  There is one exception though, Tuesday March 1st (the last green ciricle)

After the market bottomed the market did get a bit of a bounce and almost looked like it was heading back to 1350.  However, the one thing we took note of was that while the market did see a moderate decrease in implied volatility after the initial Libya panic spike, the 30 and 60 day IV moved lower somewhat together.  There wasn’t the large drop and separation between that tow that we saw directly after all of the other panic peaks.  This was something that we pointed out here on this blog, when combined with the screwy skew; we did not think the market was buying the rally.

Moving on to Today (3-2-2011), I noticed that we did see a widening of the spreads (along with a skew flattening), yet when we dropped to down on the day the spreads quickly went positive.  When we rallied back the 30 day IV did fall nicely below 60 day implied vol.  If we get another day of IV dropping (preferably more than 1%) and the spread widening, I think we may be looking at a bit of a turnaround.  Although I am leaning more toward a range bound market for the next few days.  In another blog down the line I will point out how in the times when the spread gets wide the other way it can be a signal that the market is about to take a dive. 

Do not forget to check out my article at SFO Magazine on Butterfly adjustment, you can read it here (you will need to login).  Also, I will be speaking to the ISE next Tuesday and our free webinar series starts on 3-16-2011.  You can register for both here.  

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Graph from LiveVolPro


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