iVolatility.com Scores Again on OEX!

In last week's market commentary we noted that our proprietary implied volatility calculation for the S&P 100 Index (OEX) might be more accurate at forecasting overbought and oversold readings than the S&P 100 Implied Volatility Index (VIX). Well it looks like the recent market action confirms that belief once again. While no indicator is accurate 100% of the time, refining and improving indicators is an important undertaking, especially during periods of changing markets. Let's look and see the difference in the signals provided between VIX and iVolatility's readings during the latest market downturn.

The Market's Downturn and Volatility Measurement
Since the beginning of March, the Dow Jones Industrial Average (DJIA) dropped 9.6% to 9487 on March 21. During the same period, OEX fell 11.3% to 568. While the general market was declining, an improvement was noted for the NASDAQ Composite Index (COMPQ) and the NASDAQ-100 Index (NDX), which turned off their lows while the Dow, OEX, and S&P 500 Index (SPX) continued to slide. The market's general decline began to accelerate during the quarterly expiration phase. The weakness persisted on the Monday following expiration (March 19). Even an announcement that the Federal Open Market Committee (FOMC) was easing its short-term monetary policy following its March 21 meeting was not enough to turn the tide.

VIX, the measurement of implied volatility on OEX, provided by the Chicago Board Options Exchange (CBOE) showed that the market had become oversold on March 12, with the index breaking above the 30% level. This has been a critical level for VIX in determining when sentiment has become "too bearish," based on the premiums that traders were willing to pay for puts and calls. The implied volatility level continued to rise, reaching a high of 41.99% on March 22, before turning lower, even as the underlying index continued its descent (see chart).

While the level of implied volatility continued to rise, the first indication that oversold readings were being registered by iVolatility was on March 21, the day prior to the index hitting its intra-day low. Following the close of business, iVolatility reported an implied volatility of 31.85%. As OEX hit its low of 567.66, iVolatility.com registered an implied volatility high of 36.08. On that same date, OEX began to turn higher. This compares to the oversold reading of VIX on March 12, when it pierced the 30% level. The iVolatility.com oversold signal is shown on the chart below.

Which Signal Was More Timely?
Traders who began purchasing shares or initiated bullish strategies based on the oversold readings of VIX on March 13 generally watched as OEX dropped another 33.85 points or 5.63% over the next eight days. In contrast, traders who waited until iVolatility's first oversold reading by iVolatility.com began adding to positions on the day when the index set its low.

Since the low was set on March 22, we have seen a return to a positive implied volatility signal for both VIX and iVolatility.com. The VIX signal was generated by a decisive turn in the trend while the ivolatility.com signal was generated on a crossing back below the 30% level at the close of business on the very next day, Friday, March 23.

What Should A Trader Do? Which Signal Is Better? Scott, the Strategist, Fullman writes……

As a strategist and observer of market conditions, it is important to look at as many tools as possible. I believe that using the VIX and the iVolatility.com readings together can be both rewarding and educational. VIX currently provides more timely information since it is updated frequently during the trading session, while the iVolatility.com reading is only generated once a day, following the close of business. Second, since VIX appears to be more sensitive and moves more quickly, it can provide an early warning signal as to the relationship of option premiums. The iVolatility.com signals, which have been more accurate at pinpointing overbought and oversold readings during the past several months, can be very useful in helping to define short-term market trend changes.

During the next several months, I will be conducting more extensive studies of the volatility signals generated on the iVolatility.com website. Additionally, I will be examining the data for several important market instruments, as well as for individual stocks, to determine if timely signals can be generated from such information.

Caveats
All signals, even the best signals, are not accurate all of the time. Signals that are correct more than 70% of the time can be considered as fairly reliable, while signals that are right more than 85% of the time are outstanding. No signal is correct 100% of the time. That is why it is important to use more than one indicator before making investment decisions. The more indicators that you utilize, the greater the probability that your assessment of the market should be correct, and therefore the lower the frequency of losses. However, using too many indicators can provide a loss of opportunity as the market moves. There is a very delicate balance in choosing the mix that is correct for you.

At This Time
While the markets have turned off their recent lows, risk levels remain high. A slowing domestic economy coupled with a slowing global economy could continue to depress stock prices. Additionally, corporate earnings and revenue warnings, layoff announcements, and a declining level of confidence by both consumers and investors, could hold back the fuel needed to sustain rallies over the next several weeks or months. On the positive side, there is a lot of capital available for investment, which could help lift the markets back toward their historic highs over a period of time.

Intermediate-term and long-term investors should be very selective in their stock selection and employ defensive strategies. During periods of high volatility, or for stocks with high volatility levels, one should utilize strategies such as the covered combination, covered call write, or naked put writing strategies. For stocks with low volatility levels, and therefore low premium levels, protective puts can help to provide security and limited liability during periods of weakness.

Short-term traders should consider the use of spread positions to limit premium exposure for stocks that have high volatility levels. Additionally, the use of stop points is urged.

Remember: do not undertake any positions that might result in risk levels higher than you are able to take. Capital preservation is the most important objective, especially during periods of above-average risk. Many stocks still have not reversed their negative trends.