Options are more than just instruments for investment; they also serve as indicators of market sentiment.
You know that the value of a put option in, say, Exxon Mobile (XOM) should increase when the price of XOM stock goes down. However, the value of a put may also increase when XOM stock is unchanged. Why is that? It’s due to the market thinking XOM might make a larger drop in the future than the market previously thought. Maybe XOM’s earnings are coming out. Maybe the price of oil is fluctuating. Whatever the reason, the market thinks the future price of XOM might be more volatile, and maybe have bigger price drops. Because of that, option traders will push up the value of the put option.
Options have two components to their price - "intrinsic value" and "extrinsic value." Options have intrinsic value when they are in-the-money (ITM). If XOM is currently trading $82, then the 85 strike put has $3 of intrinsic value ($85 - $82 = $3).
Extrinsic value is simply the total value of an option minus the intrinsic value. If the XOM 85 strike put is trading for $5.00, $3 of that is intrinsic. So, the put has $5 - $3 = $2 of extrinsic value. Let’s say the 80 put is trading for $4.00. It’s out of the money, and has no intrinsic value. It’s $4.00 value is all extrinsic. And it’s an option’s extrinsic value that increases when the market thinks the price of the stock might be more volatile.
The reason that options serve as such excellent indicators of sentiment is that their extrinsic value responds rapidly to changes in the market. The way we measure that is implied volatility. When the extrinsic value of an option goes up, all other things being equal, its implied volatility goes up, too. If the price of that XOM 80 put goes from $4 to $5 because the market thinks XOM might crash, and the price of XOM is still at $82, then the implied vol of that 80 put would be higher. This is why we can look at the implied vol of an option to gauge market sentiment.
Volatility measurements were created to provide insight into the precise phenomenon just described. The VIX, or CBOE Volatility Index, represents a theoretical weighted blend of prices on a range of options in the S&P 500 index. The VIX rises when the value of OTM SPX options increases. That’s why the VIX is often called the “fear gauge” because changes in demand for S&P 500 index options reflect adjustments in the market’s perception of risk.
Due to a rise in popularity of such products, volatility measurements are not only indicators of market sentiment, but also tradable instruments that can be used to take/hedge risk.
We’ll introduce the primary volatility measurements/products found in the marketplace and provide details on their composition and use in subsequent blog posts.
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Sage Anderson has an extensive background trading equity derivatives and managing volatility-based portfolios. He has traded hundreds of thousands of contracts across the spectrum of industries in the single-stock universe.