An index that looks forward, not back

This article appeared in the October 2013 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

A-VIX gauges 30-day market sentiment and volatility.

Photo of Marcus Christoe By Marcus Christoe, ASX

We often hear people talk about what the market thinks or what the market is saying. But we all know that the market is not any one individual; it is the place where buyers and sellers meet, each with their own view on particular companies and on the direction of the sharemarket as a whole.

There is a range of measures on "market sentiment" that can tell us what the sharemarket has done in the past, the most obvious being a share price chart for a particular company or an index chart for the whole market or a market sector. Sometimes we look at that chart and say the trend is up or the trend is down. But the 64-dollar question is will the trend continue?

One way of looking into the crystal ball of market sentiment is to measure volatility. The dictionary definition of volatility refers to lively or changeable. A volatile market is one that is prone to change.

Volatility is a critical component of the pricing of options. Everyone knows what the price of a share or the level of the underlying index is, expectations of dividends are pretty similar, interest rates are known, as is how much the share price has bounced around in the past - its historical volatility.

But people can have very different views on what will happen in the future. So the critical element is how confident people are in their assessment of the likely trend. If people are confident of future direction they will regard their transaction as low risk and will factor in less of a risk premium. When they are really uncertain they regard any trades based on future prices are risky, so a risk premium will be factored in. This risk can be to the downside - the stock or market may fall quite a lot. As for the upside risk, they might go up a lot.

By looking at the price of an option and feeding in all the known variables, the mystery variable is volatility. By using pricing software you can deduce the "implied volatility". If the price of the option is X, that says the overall view of investors in those options is saying that the future volatility of the underlying security is Y. As option prices vary, so too does implied volatility.

By doing these calculations, we can then say that the market, as shown by options market prices, is less confident about future direction (high implied volatility), or is quite confident the price of the underlying security won't change much - lower implied volatility.

Introducing the A-VIX

The S&P/ASX 200 VIX (A-VIX) index gauges market sentiment and expected levels of market volatility as shown by prices in the S&P/ASX 200 index options market. ASX recently enhanced the A-VIX index, to provide real-time prices rather than only end-of-day prices.

Do not be put off by technicalities about volatility and options. The A-VIX is a single number that shows if market volatility is expected to be high or low over the next 30 days. The index was 15.07 on September 30, 2013, after being as high as 21.67 and as low as 10.54 during the previous 52 weeks.

So a high A-VIX reading indicates an expected period of high sharemarket volatility - that is, a large change in the S&P/ASX 200 index over 30 days - and vice versa. Put another way, the high reading implies investors are less confident and a low reading implies greater confidence in where the market is headed.

The A-VIX's US equivalent, The Chicago Board of Options Exchange Volatility Index (VIX), is among the most widely used and reported pieces of financial information in global financial markets. The US VIX is often described in the media as "the fear index", because it shows expectations of market sentiment and volatility. But this is a misnomer. For example, the market may have been in a bear phase for some time and everyone expects that to continue. This would be shown by low implied volatility in options prices.

But suppose views start to change and people are less certain. Some think the bear market will continue, perhaps get worse, and others think a recovery is imminent. This uncertainty would be reflected in higher volatility in options prices but not necessarily because of bearish sentiment - perhaps because bearish sentiment is now clashing with a return of bullish sentiment.

The A-VIX gives retail investors the same type of information that professional investors have used for years. Its Australian focus is especially important. There may be times when the US VIX rises and the A-VIX falls, because of country-specific factors affecting sharemarkets.

In the next issue, we will look at interpreting the A-VIX.

A-VIX data is available on and reported each day in the Sydney Morning Herald, The Age and Australian Financial Review, and in the Weekend AFR.

Future developments

Investment products based on the A-VIX are expected to be launched this year and next, as the real-time index becomes more established and widely followed. The S&P/ASX 200 VIX Futures contract is being launched on October 21, and ASX expects other market participants to launch structured products, such as warrants or exchange-traded products, over the A-VIX in coming years.

In addition to using A-VIX information, investors will be able to trade their view on expected market sentiment and volatility, and over time hedge (or insure) their portfolio against anticipated higher volatility and low share prices, thus protecting their portfolio's current value.

From ASX

Read more about the S&P/ASX 200 A-VIX with this fact sheet. 

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