Volatility indexes can be useful for discovering some interesting characteristics about investor sentiment. One of the most basic relationships is that when volatility is high, the security the index is tracking is generally decreasing in price; on the other hand, when volatility is decreasing, the underlying is probably acting bullish.
Volatility measures the cost of out-of-the-money options, so when a bearish pattern approaches, people pay more for bearish put options at very low strikes to hedge long stock positions. As more and more traders expect that the underlying could plummet, options premiums rise, and the volatility index measuring the cost of such options moves higher.
When the market is on a bullish rally, however, people do not rush to make bullish bets by buying far-out-of-the-money call options. This is because markets tends to make swift drops more often than they make quick rallies, and far-out-of-the-money calls could expire before they have the chance to profit from the upside.
Thus, the volatility index typically falls as traders become bullish, because there is less demand for long-shot call options.
This has given the VIX, the volatility index of the S&P 500, the nickname "the fear gauge," because it provides a measure of how nervous investors are about the underlying market.
The GVZ is similar to the VIX, but instead of looking at S&P options, it measures the volatility of options on the SPDR Gold Trust (GLD). If investors are paying a higher premium on out-of-the-money GLD options, that would cause the GVZ to move higher.
So far we have talked about the buyers of puts and calls—but how about the sellers? Well, in a true bear market, the investors selling these puts are subjecting themselves to a lot of risk. That's because they could be obligated to buy the underlying asset at a bad price. As markets continue to drop, sellers will insist on getting paid more and more premium.
When a lot of buy orders come in, and a relatively small amount of sell orders, the volatility will spike up. But what happens when investor sentiment changes?
When a security is about to bottom out after a steep decline, and traders believe they see it coming, they will switch their position and all of a sudden start selling a lot of put options. Traders will pick levels where they are comfortable getting long the market, so that even if they do have the stock "put" to them at a low price, they are happy to own in there.
As a result of the heightened demand for puts because of gold's recent decline, puts are trading at an inflated value. If the market turns around, then selling these puts now allows a trader to profit off of the overpriced premiums for put options.
If this trade starts to be put on, then the volatility index will reflect this, because the large amount of sell orders being placed will counteract the buy orders, squashing the volatility. For that reason, when a security makes a lower low as the volatility index makes a lower high, it usually indicates that investors believe there is going to be a turnaround in the market, and this is the time to profit off of the dip.
Consider the gold ETF GLD and the corresponding volatility index GVZ. When the price of gold dropped in April to make a new low in GLD of $131.31, the volatility index GVZ spiked up to make a new 52-week high of 35.39. GLD made a slight recovery, but then continued to drop and made a new low around $115 at the end of June.
However, the volatility index did not reflect this new low. In fact, instead of making a new high, GVZ only rose to 33.51 —5.3 percent below its earlier peak.
Within the past week, GLD has started to rise. But the GVZ has already given investors a very significant indication that traders believe gold has bottomed, and that it is now time to buy the dip.
Traders have begun selling put options at inflated premiums, because they expect a turnaround in the gold market to occur. This would let them profit off of the sale of overpriced July and August out-of-the-money GLD puts. With investor sentiment changing around the precious metal, it is a good time to buy the dip and ride the rally up.