Option traders have long used volatility indices to help them determine market direction. A low volatility index on an underlying stock index indicates that traders have become somewhat uninterested in the market and this is generally forerunner to a sell off in the underlying stock index. (This could well be the case for many Asian stock indices). Empirically, a volatility index is inversely proportional to the underlying stock index; when the volatility index goes up the stock should go down and vice-versa.
A Volatility index could be viewed as a long term index of the general trends in costs of insurance (or option) premiums and it could provide useful information to buyers and sellers of such (securities or portfolio) insurance. For example, an owner of a portfolio of stocks who is very interested in seeing a measure of the general trends in the costs of protecting his portfolio from declining by using index options, would find a volatility index on the underlying stock index which is representative of his stock portfolio, very useful in giving him that information.
Volatility, like stocks, bonds and currencies, have now become an asset itself. Many investors and traders have historically traded volatility by trading options as a suitable proxy. However, it is not possible to efficiently (and precisely) trade volatility as a pure asset via options (See Risk Latte article on Volatility Conundrum on www.risklatte.com). If a volatility index becomes tradable, then investors, traders, as well as speculators can buy and sell volatility as a pure asset.
Source: http://www.risklatte.com
Neeraj Rajgarhia
Summer Intern - Technical Analyst
DENIP Consultants Pvt. Ltd.
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