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Every so often, especially when markets are extremely volatile, the financial press remarks on the VIX index, which is considered one of the best ‘fear and greed’ indicators in the US market. There is no equivalent in the UK, but of course CFD traders can use other volatility measures such as standard deviation or average true range functions. Nevertheless, knowledge of the VIX is useful in measuring risk in terms of ‘fear’ levels.

The VIX was created as a measure of implied volatility in the US, and followed on from the development of work in the options market relating implied and historic volatilities. It is widely used now as a useful snapshot of market psychology.

Development of the Vix

The first VIX was developed by in a paper by Professor Robert E. Whaley of Duke University. It was presented to the Chicago Board Options Exchange in 1993, and it began with a weighted measure of the implied volatility of eight S&P 100 index “at the money” put (right to sell) and call (right to buy) options. An “at the money” option means that the option chosen gives the right to buy or sell at a level close to or at the underlying market price, and the premium for each option thus reflects the implied volatility of the index.

Ten years later, the CBOE expanded the range of options and based it on the broader S&P 500 index, which gave a more accurate view of future market volatility.

The VIX formula uses a kernel-smoothed (statistically weighted) estimator that takes as inputs current market prices for all “out of the money” (options containing only time value) calls and puts for the next month and second month expirations. From this, an estimation of the implied volatility of a synthetic, “at the money” option on the S&P 500 index with 30 days to expiry is created.

What the VIX level indicates

The VIX is quoted in terms of percentage points and represents in essence the expected movement in the S&P 500 index over the next 30 day period, which is then annualized.

If say the VIX is at 15, this represents an expected annual change of 15% in the index. From this it can be inferred that index option pricing expects the S&P 500 to move up or down 4.33% over the next 30 day period (15% divided by the square root of 12). You can see the similarity to standard deviation measurements here.

So if the S&P 500 stands at 1500, this means that index options are priced with the assumption of a 68% likelihood (one standard deviation) that the 30 day change in the S&P 500 will be less than 64 points up or down.

For this reason, the VIX pricing is different to many other technical indicators, and the rule of thumb is that a VIX level above 30 reflects a large amount of volatility as a result of investor fear or uncertainty. Levels under 20 are generally seen in quieter, less volatile market conditions.

Because the VIX aims to measure market sentiment, it works out how much people are willing to pay to buy options on the stockmarket, and because it is viewed as a measure of ‘fear’ this would usually represent the price of put options to protect against declines.

During very calm periods, the VIX may head down towards around 12, but it is very rare for it to go much lower – there has to be a price for taking an option on market movements however quiet the background may seem.

At the other end of the scale, values above 60 have been seen during market panics. What many traders often look for is a sharp reversal in the VIX to indicate or confirm a possible turning point. A VIX price of 60 would mean it is five times more expensive to buy options than in the quietest times (VIX of 12), and these levels do not typically last long.

The VIX can actually be traded itself and there are both futures and options on the indicator.

A word of warning

Although the VIX is used as an important representation of overall sentiment for equity options, this is not strictly true. The VIX, being an index-based implied volatility measurement, has a slightly different dynamic to individual equity option pricing. Occasionally, equity and index options are uncorrelated, and in particular, the VIX is limited to a 30 day period measurement, while for equity options, the most liquidity is usually found between two and six months to expiry.

The other point is that market movements often relate to how much influence ‘flavour of the month’ sectors have on the index. It might be highly volatile in financial stocks, with the current sub-prime crisis a case in point, and if the weighting of these sectors is high, it might influence traders in the pricing of options in other, less volatile sectors.

Every so often, especially when markets are extremely volatile, the financial press remarks on the VIX index, which is considered one of the best ‘fear and greed’ indicators in the US market.

About the Author:
Mike Estrey is the Head of Research for Blue Index, specialists CFD Brokers, providing seminars on how to trade CFDs and offering a Live Trading Simulator.

Article Source: http://www.eArticlesOnline.com

What is the TRIN anyway?

The TRIN (an acronym for TRading INdex) is an indicator which helps to determine the breadth, or sentiment, of the market. Developed in 1967, it is often referred to as the Arms Index after it's author, Richard Arms. The TRIN measures the number of advancing issues divided by the number of declining issues, which is then divided by the advancing volume divided by the declining volume. This may sound confusing, but the equation below should make it clear:

TRIN = ( Advancing Issues / Declining Issues ) / ( Advancing Volume / Declining Volume )

Interpreting the TRIN

Most commonly, traders will look to the value of the TRIN. When at 1.0, the market is considered balanced. Any value below 1.0 is considered bullish, while any value above 1.0 is considered bearish. This may be confusing at first, but you just have to remember that the direction of the TRIN is basically showing the inverse of the direction of the market.

While many only pay attention to the value of the TRIN when gauging market sentiment, I believe that its direction is of far greater importance. If you do not pay attention to where the TRIN has been, you can easily be deceived by the market. Here is a good example:

A trader is looking to place a trade and sees that the value of the TRIN is currently at 0.84, indicating the market is bullish. A few moments later, the trader sees the TRIN has lowered down to 0.68, while the market is starting to rise. At this point, he decides to take a long position, only to see the market swiftly turn back around and stop him out.

What went wrong here? Although the value of the TRIN was portraying a bullish market, this trader didn't take into account that it was hitting a major trendline (drawn from the previous lows) at 0.68. As soon as he executed the trade, the TRIN began to turn and slope upwards, and continued to follow its trend.

Slope, Trendlines and Divergence

In order to see the slope of the TRIN, you will want to make sure it is shown as a line based on the close of whatever time interval you choose. The slope is simply which direction the TRIN is currently heading in. A sharp change in slope, especially off of an extreme level or a trendline, will give you a strong indication of the market sentiment. Always pay attention to the slope rather than the value.

Trendlines drawn from the highs and the lows of the TRIN are just as valid as trendlines drawn on price. A strong bounce off of a trendline indicates that the trend the market is currently following will continue. On the other hand, a strong break indicates a possible change of trend in the market. Truthfully, The best way to learn about trendlines is through experience, and once you begin draw them and see how the TRIN interacts with each one, the better you'll understand which bounces and breaks are valid and which ones are meant to 'fake you out'.

Divergence is simply the difference between the highs or lows of the TRIN in relation to the highs or lows of the market you're trading. It is a bit different than looking at divergence on the MACD or the RSI because the TRIN is an inverse of price. So, instead of looking for price to make a lower low while another indicator, say the MACD, makes a higher low, you will want price to be making a higher high while the TRIN is making a higher low or vice versa. Divergence is an extremely powerful pattern, and will very often occur when the trend is changing and result in large moves.

I hope that this information has helped, and remember, the best way to understand the TRIN is through experience!

Conner Hayes is a full time day trader and developer of the Simple Trend Trading methodology. To learn how he trades the e-Mini S&P 500 futures with a 75%+ win ratio, please visit Simple Trend Trading This article is free for republishing
Source: http://www.articlealley.com