Modifying the Volatility Index by S. Jack Karczewski
Here's the scoop on the volatility index as an analytical tool for identifying extremes in market sentiment.
Every trader and investor recognizes that the stock market has some degree of volatility because clearly, the market does not move in a straight line. However, traders with a certain amount of market experience eventually come to view market volatility as both a positive and a negative. It can be seen as a negative, because volatility is an unknown and unknowable measure of risk - how quickly will a market adjust to the new state of economic affairs? - and it can be seen as a positive, because every investment and every trade relies on that very same price movement or volatility to realize a profit.
The volatility of a stock or a futures contract is more important to traders in the options market. The price movement of the underlying instrument from which the option derives its price determines the profitability of the option's contract at expiration. It follows, then, that the price of an option reflects options traders' combined expectations of where the underlying instrument may be when the options contract expires.
If you study the options markets, you can learn what the options markets' prices imply about the market's future. This implied volatility is a popular topic to traders; in fact, there is an index based on the implied volatility concept, created and disseminated during the day by the Chicago Board Options Exchange (CBOE), called the volatility index. This index is the implied volatility of a group of Standard & Poor's 100 index options.