Market Insights

Volatility has risen in the stock market, potentially increasing the importance of indexed products. This post will cover some basic points you may want to know.

What Is Volatility?

What is volatility, and why does it matter? Volatility measures how much a stock or index tends to move on an annualized basis. It’s calculated historically and on an implied basis.

Historical volatility measures how much a stock or index has moved in a given time period to establish future probabilities. For example if 21-day historical volatility is 10 percent, it means that a stock is likely to rise or fall 10 percent from its current price over the next year.

Implied volatility looks at options premiums to see how much of a move is expected by the derivatives market. Generally speaking, higher options prices suggest traders expect bigger moves.

Not surprisingly, historical and implied volatilities move together. Historical volatility increases when stocks are rising and falling sharply. Implied volatility follows because options traders react to the increased turbulence in the underlying market.

What Is the VIX?

Cboe’s Volatility Index (VIX) provides investors with a measure of volatility in the stock market. VIX measures the implied volatility on S&P 500 options. Higher readings mean that the index is moving more sharply.

VIX is also known as a the “fear” index because it tends to jump when the S&P 500 is dropping. Investors can therefore use VIX to gauge sentiment and market behavior.

However just because the VIX is high doesn’t mean that stocks are going down. After all, volatility goes both ways. The main point is that volatile markets tend to drop more quickly and rise more quickly.

Volatility and Correlation

Another major point about volatility is that it correlation increases. In other words, stocks move together in a volatile market. They drop mostly in unison and rebound mostly in unison. After all, when market crashes and traders grow fearful, they tend to sell most stocks. But when things are calm, investors are more interested in picking individual stocks.

As a result, it can be more straightforward to focus on indexed products when volatility is high. Investors may have more success picking individual stocks after volatility subsides.

Here’s another way to think about it: More of a stock’s move results from the broader market (index) during periods of volatility. Therefore, it can make sense to trade the index directly rather than individual stocks. Once conditions calm, investors may have more success picking stocks.

Trading Indexes

So if indexes dominate in volatile markets, what products should investors know about? There are four major indexes. Each have exchange-traded funds (ETFs) and futures.

Exchange-traded funds are mutual funds that trade like ordinary stocks. They also have options, letting investors hedge moves in the entire market with a single product.

Futures are derivatives using special account types. They let investors go long and short the same indexes, including extended trading hours. Because they use margin, customers need to understand their unique risks (including the possibility of losing more than an initial investment).

Futures also have different symbols and expirations. A month code is added to the root (H for March, M for June), then the year. See this table for more on important futures contracts:

Important Information

This content is for informational and educational purposes only. This is not research or a recommendation regarding any investment or investment strategy.  Any opinions expressed herein are those of the author and do not represent the views or opinions of TradeStation Securities, Inc. or any of its affiliates. Investing involves risks. Past performance, whether actual or indicated by historical tests of strategies, is no guarantee of future performance or success. There is a possibility that you may sustain a loss equal to or greater than your entire investment regardless of which asset class you trade (equities, options, futures, digital assets, etc.); therefore, you should not invest or risk money that you cannot afford to lose. Before trading any asset class, first read the relevant risk disclosure statements on the Important Documents page, found here: www.tradestation.com/important-information.