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Volatility: A Primer

Tuesday, 6 Dec 2011 | 6:15 PM ET

In the last three years, the stock market has gone on an unprecedented roller-coaster ride, with price swings of 10 percent or more—sometimes in a matter of days.

It's called volatility, and it's a hot topic on Wall Street. Some trade it like an asset class. Others want protection from it. But, everyone watches it.

On Closing Bell this week, we're taking a closer look at volatility…why has it become so important? How is it traded? What does volatility say about the stock market and where it is going?

But let's start with the basics: what is volatility?

What is volatility? Volatility is a way of measuring the likelihood of shocks to the markets, so as volatility rises, the likelihood of shocks (price swings) rises.

Volatility affects strategies in different ways. Many traders and investors —perhaps most — hate volatility because it messes with their returns and is associated with uncertainty. Uncertainty causes stocks to decline.

But not everyone hates volatility: many rely on it to make money. Statistical arbitragetraders (many of whom use high frequency trading) need volatility because it allows them to play the spread: they buy the bid, sell the ask, and when that gap is wide (as it often is during periods of high volatility) they make more money.

Others trade volatility as an asset class: they are willing to bet that volatility will increase or decrease.

Still others just want to buy protection against volatility.

Why has volatility become so important? There is a relationship between volatility and direction of the market. When investors are uncertain about what will be happening in the markets and the economy (as they are now), the markets don't generally do well. That's because most are long-term buy-and-hold investors. They allocate between stocks, bonds, commodities, and cash.

With volatility (uncertainty) high, many investors allocate out of stocks. High volatility is associated with high correlation between stocks: everything moves up or down in tandem. That makes it very difficult to pick stocks. There is no point in stock picking when everything is driven by macro events.

What causes volatility? Stock prices and their derivatives (futures and options) move on several factors: 1) earnings and guidance from corporations, 2) relative strength of one company versus another in the same space (Coke vs. Pepsi , Home Depot vs. Lowe's ), 3) supply and demand for individual stocks and for equities in general, 4) macroeconomic news (employment, GDP, etc.), and 5) the degree of certainty investors have about earnings in the near future.

That last factor — certainty, or, rather, uncertainty — is a key to understanding volatility. Because no one knows what will happen in the future, traders can only make assumptions based on probability. And they have devised an instrument to try to help them make guesses about volatility in the near future.

The CBOE Volatility Index (VIX). We often think the VIX is a "fear indicator." It measures the cost of buying options (puts and calls) for the S&P 500 one month out. More specifically, it measures the implied volatility of the options.

What does it mean when the VIX is at, say, 30? It means market participants think the S&P 500 might move up or down 30 percent on an annualized basis over the next 30 days.

How do they know that? They don't know it for sure, but they make guesses based on the supply and demand for putsand calls. This collective "wisdom of the markets" isn't right all the time, but it tells you how exuberant or afraid traders are, and enables market makers to put a price on volatility. For example, if there are 10 times as much demand for puts as for callsat the same strike and same expiration, you can bet the price of puts are going to be much higher.

There are several factors that go into pricing options: the underlying price of the stock, the strike price, the days to expiration of the option, the prevalent interest rate, and what if any dividends are paid over the life of the option.

But arguably the most important factor is implied volatility. It's the projection of how much — on a percentage basis — trader think a stock or index will be up or down during the period of the option.

Why is implied volatility so important? Because the other factors that go into pricing options — the stock price, the days to expiration, interest rates, dividends — are all known. What's not known is how volatile the stock or index is going to be. Implied volatility is just a mathematical attempt to estimate how volatile the markets are going to be, again based on demand for puts and calls in that period.

In general, the higher implied volatility is, the higher options prices will be.

In dull mathematical terms, implied volatility is the projection of an annualized one standard-deviation move in the stock or index price (in this case, the S&P 500) over the life of the option. One standard deviation means there is a 68.2 percent chance that the stock or index will stay in a band up or down on an annualized basis in the next 30 days.

Let's say the S&P 500 is trading at 1,200, and options prices indicate 20 percent implied volatility. Twenty percent of 1,200 is 240, so this implies a 68 percent chance that the S&P will close between 960 (1,200-240) and 1,440 (1,200 + 240) a year from today.

We can take this a little further. Two standard deviations means twice the price swing (240 x 2 = 480): there is a 95.4 percent chance the S&P will land between 720 (1,200-480) and 1,680 (1,200 + 480) a year from today.

How Volatility Is Played

We can go out even further. Three standard deviations means three times the price swing (240 x 3 =720): there is a 99.7 percent chance that the S&P will land between 480 (1,200-720) and 1,920 (1,200 + 720) a year from today.

One important note: these are estimates on what market participants think will happen on an annualized basis (over the next year).

What about what participants think will happen in the next month? To get the estimate on a monthly basis, divide 30 by the square root of 12 (3.46). So if the VIX is at 30, divide 30 by 3.46 and you get 8.6. The market believes the S&P 500 will have a one-standard deviation chance of moving 8.6 percent in the next 30 days — up or down.

Why did the VIX blow up in August? With a VIX at 48 — which is what it hit in the first week of August, the markets believe the S&P 500 has a one-standard deviation chance of moving 13.9 percent on an annualized basis in the next 30 days (48 divided by 3.46) — that is a huge swing!

In fact, it went beyond that — the S&P 500 went from 1,338 on July 26 — when the VIX was at 20 — to 1,119 on August 8th, when the VIX went to 48. That is a move of 16 percent in a few days — way outside the normal trading parameters!

It happened for several reasons: 1) surprisingly poor U.S. Q2 GDP data (well below expectations), 2) a prolonged, embarrassing battle to extend the U.S. debt ceiling that greatly damaged the U.S. reputation abroad, 3) Italy and Spain suddenly coming on the radar screen of traders who were formerly worried mostly about Greece, and — the final blow — 4) the dramatic S&P downgrade of U.S. debt on the evening of Friday, August 5.

How volatility is played. Up until recently, the VIX was not something you could invest in. It was merely an indicator. That changed several years ago, when VIX futures came online, then VIX options on futures.

This is an important point: you cannot buy a "cash" VIX, or the price that the VIX is trading at at any one moment. When you "buy the VIX" you are typically buying VIX futures or options.

In 2009, Barclays introduced VIX ETNs, which tracks performance of near-term VIX futures. Since then, there are other exchange traded products that have been introduced.

The VIX is the most transparent way to play volatility, but traders have been making plays on volatility for a lot longer than that.

The simplest way is to use options — buying puts and calls. Volatility is one of the elements embedded in options, every time an investor buys a put or a call. Investors can use options to protect against volatility.

Of course it can get much more complicated — there are other ways professional can play (buy or sell) volatility. The most common is volatility swaps...say you think volatility might be going up. You can buy the VIX at, say 30 from a trader...in a swap, if the VIX it goes up, you make money...if it goes down, the trader you bought it from makes money (and you lose money). It's a zero sum game: someone always loses, and someone always gains.

Who uses volatility? There are several types of investors who use volatility. Some just want protection against swings in the market, others sell volatility to make money as a side to what they do, and still others actively trade volatility as an asset class.

1) Institutions like asset managers use it to protect portfolios and to generate some small yield on top of their returns (usually by selling calls).

2) Hedge funds use volatility in different ways depending on their strategy: multi-strategy, including volatility arb funds, will trade volatility purely as an asset class.

To do this, you have to have an opinion on the direction of volatility. For example, historically the VIX very rarely stays above 30 for more than a short period — a few weeks is rare. Knowing this, some traders have played a "mean reversion" trade, selling the VIX when it is above 30, and buying when it is at its historic norm of roughly 20.

Long-short equity funds, on the other hand, act like institutions: they use volatility to protect their assets and generate yield.

3) Pension funds: Because they need to provide a fixed payout, U.S. pension funds typically buy protection against volatility.

4) Insurance companies. These are often the most sophisticated users of volatility, often to hedge variable annuities. There are different types of variable annuities, where insurance companies guarantee the principal and a return linked to the market. To protect themselves, insurance companies buy S&P puts of very long duration, out to 10 years.

5) High net-worth individuals. They usually buy structured notes, which are individually crafted financial insurance policies. Like annuities, the principal is typically guaranteed, along with some type of coupon (say, 4 percent per annum). The maturity of those notes are typically three to five years and are sold by large banks. To protect themselves, banks also buy puts, usually for the length of the note.

6) Market makers/proprietary trading desks. Many institutions — banks, insurance companies, asset managers — are looking to hedge against volatility. What they all want is tail risk protection: protecting against large declines in the markets. Where do they go? This brings us to our last group: market makers who take the other side of the trade. Many market makers also run proprietary trading desks, who also actively trade volatility for their own accounts.

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