INDEX INTELLIGENCE: VXD—Using the New Volatility Index By Frederic Ruffy, Optionetics.com 3/31/2005 11:15 AM EST
The Chicago Board Options Exchange [CBOE] began disseminating quotes on a new index last week. It is a volatility index similar to the widely watched CBOE Volatility Index ($VIX). However, rather than using the S&P 500 ($SPX) options to compute the index, the new barometer of market volatility is based on the Dow Jones Industrial Average ($DJX). Strategists can use the new benchmark, not just to make trading decisions with respect to the Dow Jones Industrials, but also to gauge the prevailing levels of bullish or bearish sentiment in the stock market.
The Dow Jones Industrial Average ($INDU) is familiar to most investors. Created in 1896 by Charles Dow, the industrial average is one of the more widely watched barometers for the performance of the US stock market. Indeed, it is often quoted in financial press and even on the nightly news. It is a tool that helps investors make sense of the daily swings in the stock market. It’s a shortcut. If, for example, the Dow moves up on the day, stocks did well. If the industrials move lower, stocks had a bad day.
Originally, the Dow consisted of a dozen industrial companies, which Charles Dow considered to be the most important companies in the late 19th century. Today, the average consists of thirty stocks—with twenty-eight stocks listed on the New York Stock Exchange including Citigroup (C), General Electric (GE), and Exxon Mobile (XOM) as well as two Nasdaq listed stocks—Microsoft (MSFT) and Intel (INTC). Only General Electric remains as one of the original Dow stocks.
While many investors have used the Dow to make sense of the market’s daily performance through the years, option strategists can also trade the index. There are two ways to do so. The Dow Jones DIAMONDS (DIA) is an exchange-traded fund that holds the Dow thirty stocks. It is designed to equal 1/100th of the industrial average. The Dow Jones Industrial Index, on the other hand, is a cash index similar to the industrial average. However, the DJX is also equal to 1/100th of the Dow. So, on Thursday, with the Dow trading at 10,500, the DJX was reading 105 and the DIA was near $105.00 a share.
Options are available on both the DIA and DJX. In order to make the Dow Jones Industrial Index options easier to trade, the Chicago Board Options Exchange recently launched the CBOE Dow Jones Industrial Average Volatility Index ($VXD). Listed under the symbol VXD, the new index is “designed to reflect investors’ consensus view of future (30-day) expected market volatility in the Dow Jones Industrial Average [DJIA],” according to a January 12, 2005 press release from the Chicago Board Options Exchange [CBOE].
Like the CBOE Volatility Index, or VIX, the new volatility is computed using a model and options prices. The VIX is based on the prices of a basket of S&P 500 Index options. When it rises, it indicates that traders expect the S&P 500 Index to become more volatility. A falling VIX indicates that traders in the options market expect the S&P 500 Index to trade more quietly. Similarly, the Nasdaq Volatility Index ($VXN) is used to track the expected volatility of Nasdaq 100 Index options ($NDX). Traders use the VXN to gauge expected volatility within the Nasdaq Stock Market, which is dominated by many large cap technology stocks. The VXD is computed using the expected volatility priced into DJX options. So, it will be used to track the volatility associated with options on the Dow.
Traders can use the volatility indices, including the new VXD, in several ways. For one, the indices provide a real time and historical looks at expected volatility in the index market. For example, when the VXD falls to low levels, the volatility priced into Dow Jones Industrial Average options is low. A low VXD might occur after the Dow has performed well and investors don’t expect to see much volatility. In that case, the low VXD indicates that the options on the Dow are relatively cheap. On the other hand, when the volatility index rises, it indicates that the premiums on the Dow are rising and becoming more expensive—which generally occurs if the major averages have been falling and investors expect the stock market to exhibit high levels of volatility. In that case, the VXD is high and the options on the Dow have become more expensive.
On Thursday, the CBOE Dow Jones Industrial Average Volatility Index edged up .15 to 12.70. Is this high or low? Well, given that the VXD has been around a little more than a week, it’s difficult to say what the normal range might be. In order to get a better idea, traders can look at the implied volatility of DJX options. The 2-year chart below was created using Optionetics Platinum software. For example, the blue line reflects the implied volatility of 30-day DJX options. It is near 12% and above its recent low of 10%. However, the IV also remains well below levels two years ago when it was near 20%. So, using this chart, the volatility of the Dow has been in a range between 10% and 20% during the past two years. If the VXD is now 12.7%, the Dow volatility index is closer to the lower end of that range, which indicates that IV on the Dow is relatively low and therefore these options are relatively cheap.
The volatility index can also be used to gauge market sentiment. For example, if the VXD is low, the market expects quiet trading, which occurs when sentiment is primarily bullish or complacent. From a contrarian view, this type of sentiment urges caution because sentiment often turns very bullish or complacent just before the stock market takes its next trip south. So, when the VIX, VXN, or VXD fall to low levels, market sentiment is bullish or complacent and it is time to look for a possible market reversal to the downside. The opposite holds true when the volatility barometers spike higher. Extremely high readings from the volatility indices often coincide with market bottoms. So, when VXD spikes to the upper end of its range, it might be a sign that the market is overbought and it’s time to look for bullish trades using the Dow Jones Industrial Index or the Dow Jones DIAMONDS.
Frederic Ruffy Senior Writer & Index Strategist Optionetics.com ~ Your Options Education Site
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