Measure and Invest in Market Fear With a Smile

Last week I covered one of the important tools I use, parabolic patterns. Today, I would like to cover volatility and how you can use it for binary profits.

Surge-and-sell market turbulence can be translated into a quantifiable property known as volatility. Once we “map” volatility, we can trade it more effectively. The trick is that there are a lot of ways to measure volatility.

I won’t bore you with all the technical aspects of it. But I do want to clear up a common misconception. Some people believe that the opposite of volatility is no movement at all. That is not true. Consider the human heartbeat. If it’s steady at 65 beats a second, then the volatility is zero. That doesn’t mean it’s standing still!

No, volatility is when the rate of change in movements becomes extreme.

For a look at what that means for technical charting, check out the chart below. It shows the co-movements of the AUDUSD’s one-month volatility against the AUDUSD spot.

They are in tandem, with peaks and troughs in volatility pointing to reversals of the price direction. So when a volatility spike shows up, it’s a good time to bet on the underlying investment going the other way.

#-ad_banner-#For a more focused reading of volatility, we can use volatility smiles.

Volatility smiles are a type of charting that provides a shape for investor fear and greed. It represents the volatility of options at different distances from the spot price. If market volatility were neutral, charting the volatility values for puts and calls would form a shape like a smile.

In reality, however, volatility smiles are few and far between. Most of the time, sentiment favors one side or the other. When one side is being favored, instead of a smile in the volatility curve, there’s a skew or smirk.

Lately most option market are NOT smiling.

For instance, last week a chart for crude oil showed a big skew on the put side. Premium prices for puts were more expensive than calls at the same distance from the at-the-money spot price. It was a clear signal of very bearish conditions. Volatility levels for options were in the 50% range. It wasn’t parabolic, but it was sufficient to warn that it was time to look at the calls side of oil.

Last week the three-month volatility surface shows a change.

Notice the shape has begun to curve up on the call side. It is no longer purely bearish. Traders are beginning to shift their sentiment away from extreme bearishness on oil. This tells us to not be afraid to look for buying opportunities in oil.

Now take a look at the USDJPY volatility smile.

The volatility of the calls is balanced by the volatility of the puts — nearly a perfect smile. For the same distance from the spot, the volatility of oil is five times the volatility of the USDJPY. This clearly provides evidence that investors have ambivalent sentiment on the direction of the USDJPY.

If you’re still not convinced about using volatility smiles as a measure of market sentiment, look at the volatility smile of the Chinese Renminbi.

Does the market sentiment expect it to strengthen or weaken? There is a clear and very steep skew to the call side. But the put side is also coming alive. Take notice — this may mean that bets on a stronger Renminbi in the near future are not that certain!

The trading action implications in following volatility smiles are clear. They are signatures of the war between bullish and bearish sentiment. When there is a skew to one side, it’s not a predictor of a reversal — but it is a warning of a potential reversal. When the volatility surface moves away from a smile, the conditions are ripe for betting the other way.

Ultimately, the market tries not to be skewed in one direction for too long. You can and should bet on that.