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INDEX INTELLIGENCE: VXN—Bearish Divergence?
By Frederic Ruffy, Optionetics.com
6/22/2004 11:30:00 AM

http://www.optionetics.com/articles/article_full.asp?idNo=10596

During the past few days, technology stocks have been facing a bit of selling pressure and the Nasdaq100 Index ($NDX) has been trading lower. At the same time, the Nasdaq 100 Volatility Index ($VXN), which measures the expected volatility of Nasdaq 100 Index options, has also been falling and is now setting new all-time lows. The drop in the volatility index amid falling stock prices in the technology sector is unusual. More often, the Nasdaq 100 and the VXN will move in opposite directions. So, why is the volatility index not rising this time? In order to better understand, let’s examine these two indexes and see what’s been happening with each of them lately.

The Nasdaq 100 Index consists of Nasdaq-listed stocks. To be specific, the index includes the one hundred largest non-financial stocks trading on the Nasdaq Stock Market. Furthermore, the index is weighted by market value. For that reason, large technology companies like Microsoft (MSFT), Cisco Systems (CSCO), and Intel (INTC) dominate the index. Table 1 (below) shows the top twenty components and their respective weightings within in the NDX today. Notice that these twenty companies account for 56.4% of the total index.

NDX Component
Symbol
% of Index

Microsoft Corporation
MSFT
8.15

QUALCOMM Incorporated
QCOM
5.55

Intel Corporation
INTC
5.40

Cisco Systems, Inc.
CSCO
4.59

eBay Inc.
EBAY
3.68

Dell Inc.
DELL
2.79

Amgen Inc.
AMGN
2.73

Nextel Communications, Inc.
NXTL
2.65

Comcast Corporation
CMCSA
2.30

Oracle Corporation
ORCL
2.03

Biogen Idec Inc
BIIB
2.00

InterActiveCorp
IACI
1.96

Maxim Integrated Products, Inc.
MXIM
1.96

Starbucks Corporation
SBUX
1.90

Yahoo! Inc.
YHOO
1.75

Applied Materials, Inc.
AMAT
1.44

Apollo Group, Inc.
APOL
1.42

Xilinx, Inc.
XLNX
1.40

Linear Technology Corporation
LLTC
1.39

Electronic Arts Inc.
ERTS
1.30

Total

56.38


The Nasdaq 100 Volatility Index trades under the symbol VXN and offers a real-time gauge of the expected volatility of Nasdaq 100 Index options. The formula used to compute the index lies beyond the scope of this article (but is available on the Chicago Board Options Exchange web site, cboe.com). Basically, the VXN measures the levels of volatility currently priced into NDX options. It tells us what investors and options traders expect the volatility of Nasdaq stocks will be in the future. When the volatility index rises, market players expect volatility to increase going forward. Those expectations are being priced into Nasdaq 100 Index options. On the other hand, when VXN falls, traders are pricing in the prospect of lower volatility.

Since the Volatility Index is a measure of expected volatility, some market watchers also use it as a barometer for investor sentiment. In that respect, it is similar to the more widely watched CBOE Volatility Index ($VIX). The VIX is sometimes called the market’s “fear gauge” because it rises when investors become nervous. The VXN works in a similar manner. If it is high, investors are a bit nervous or fearful about market conditions. They expect volatility to rise. On the other hand, when the volatility index is low, traders are bullish or perhaps complacent. If so, they expect market volatility to remain low.

The chart below shows the six-month change in both the Nasdaq 100 and the Nasdaq Volatility index. The Nasdaq 100 Index has been trending modestly lower during the past few months and now sits well below its yearly highs. The volatility index, meanwhile, has been jumping higher and lower. The index spiked up towards 30% in mid-May before heading lower. The jump in the VXN also coincided with a short-term bottom in the Nasdaq 100. From a contrarian’s view, this makes sense because market turning points often occur when investor sentiment becomes too pessimistic or bearish. Notice that a similar situation unfolded in mid-March—when the VXN spiked higher before a rally in the Nasdaq 100 Index.

Lately, however, VXN has been falling. In fact, the index is now trading at an all-time low. Furthermore, the recent decline has occurred amid falling stock prices. During the past two weeks, the Nasdaq 100 Index has fallen from 1,480 to 1,450. Therefore, contrary to what one might expect, the recent decline has not stirred up much anxiety or fear. Instead, the volatility index continues to set new lows. From a contrarian view, this divergence is a bearish omen. It indicates that investors and traders are too complacent, which is often the type of sentiment that prevails before stocks tumble.

While the low VXN is perhaps a sign of complacency and bullishness among investors, there is another important reason why it is low. Namely, the market has been trading very quietly for several months. To illustrate, the table below shows the daily price moves of the Nasdaq 100 Index since the end of April. The average daily point change in the index during the past month and a half has been less than twelve points. The average daily percentage change in the Nasdaq 100 has been less only .8%, which is extremely low by historical standards. Therefore, the VXN is low, not just because investors are bullish or complacent, but because actual levels of market volatility have also been low for quite some time.

Date
NDX Close
Daily Point Move
Daily % Move

4/30/04
1401.36



5/3/04
1415.29
13.93
0.99%

5/4/04
1422.11
6.82
0.48%

5/5/04
1428.42
6.31
0.44%

5/6/04
1415.6
-12.82
-0.90%

5/7/04
1406.19
-9.41
-0.66%

5/10/04
1397.1
-9.09
-0.65%

5/11/04
1421.89
24.79
1.77%

5/12/04
1414.83
-7.06
-0.50%

5/13/04
1417.09
2.26
0.16%

5/14/04
1399.85
-17.24
-1.22%

5/17/04
1379.9
-19.95
-1.43%

5/18/04
1397.47
17.57
1.27%

5/19/04
1396.34
-1.13
-0.08%

5/20/04
1396.87
0.53
0.04%

5/21/04
1408.17
11.3
0.81%

5/24/04
1413.97
5.8
0.41%

5/25/04
1447.72
33.75
2.39%

5/26/04
1453.87
6.15
0.42%

5/27/04
1463.11
9.24
0.64%

5/28/04
1466.22
3.11
0.21%

6/1/04
1468.54
2.32
0.16%

6/2/04
1464.22
-4.32
-0.29%

6/3/04
1445.21
-19.01
-1.30%

6/4/04
1455.04
9.83
0.68%

6/7/04
1491.45
36.41
2.50%

6/8/04
1495.97
4.52
0.30%

6/9/04
1469.5
-26.47
-1.77%

6/10/04
1481.27
11.77
0.80%

6/14/04
1458.64
-22.63
-1.53%

6/15/04
1479.2
20.56
1.41%

6/16/04
1479.99
0.79
0.05%

6/17/04
1464.03
-15.96
-1.08%

6/18/04
1464.65
0.62
0.04%

6/21/04
1453.23
-11.42
-0.78%






Average Daily Point Change

11.91
0.82%


While the recent period of low volatility has helped drive VXN to all-time lows, it is also making it more difficult for options traders to generate profits with directional trading strategies in the technology sector. In many cases, tech stocks are not moving fast enough to make up for the negative impact of both time decay and falling implied volatility. In this environment, it makes more sense to take a longer-term approach and even set up trades like diagonal or calendar spreads. Then, wait for VXN to begin moving higher in anticipation that investor sentiment is beginning to change, which would probably mean that market volatility is making a comeback.


Frederic Ruffy
Senior Writer & Index Strategist
Optionetics.com ~ Your Options Education Site
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