This is the 4th part in our series on the edge behind the market sentiment widget. You can see part 3 here, and all related articles here. As you remember, the market sentiment is a quantitative system that is composed from several indicators, designed to give the trader a better understanding of market sentiment and enable him to better adjust his trades accordingly.
In this part I wish to explain about the vertical axis of the widget – the Implied Volatility.
The volatility data is implied volatility of the market – The VIX index. It is represented on the Y axis. When the indicator is at the top of the chart the IV is high, and when it is in the bottom – the IV is low.
The volatility indicator is cyclical, so when the IV is high (squares labeled I or IV) – You should use strategies that profit from volatility drop, and when IV is low (Squares labeled II or III) – You should use strategies that profit from volatility rise.
The Indicator ranks the 200 last values of VIX, normalized to 100. When checking how current values effect future values – we see a clear indication that when the value is high – future value will be low and vice verse.
We checked the results of the IV indicator from 2005 – 2015 (10 years). We checked the average change in VIX, compared with different values of percentile rank.
When IV is High:
We can see that the average change of the VIX over 5 days is 0.8%. When the VIX percentile value is above 50% (above median) the subsequent VIX return is -0.8%. When the VIX percentile value is above 90% – The subsequent VIX return is -1.9% (in 5 days). We can see that the VIX future return when percentile is high is negative.
When IV is Low:
We can see that when the VIX percentile value is below 50 (below median) the subsequent VIX return is 2% – positive. We can see that the subsequent VIX return when VIX percentile is low is positive and substantially higher than the base result.
The Backtested results affirm the market “wisdom” of buying low IV and selling high IV. When we use this in the context of the market widget, we can better position ourselves within the market.
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