Stocks & Commodities V. 23:3 (50-54): Market Sentiment Extremes by John Jagerson & S. Wade Hansen

Stocks & Commodities V. 23:3 (50-54): Market Sentiment Extremes by John Jagerson & S. Wade Hansen

The ability to pick up on and properly interpret minute signals in the market dictates the distinction between success and failure. Here’s how implied volatility can help.

Small vibrations — a large investor begins buying calls. Virtually imperceptible movements — a hedge fund manager raises his stop-loss levels. These are telltale signs a change is coming. The ability to pick up on and properly interpret these minute signals means the difference between success and failure in the marketplace. Bulls and bears alike push market sentiment to extremes. Whether the imbalance is positive or negative, the market must eventually turn and correct itself. But before it does, it will often announce its intentions through implied volatility.

IMPLIED VOLATILITY

Implied volatility is an estimate of future price changes. While historical volatility is an easily quantifiable measurement of past price movement, implied volatility is an emotionally based guess determined by investors as they buy and sell options. Implied volatility, or investor fear, increases as investors become bearish toward the market and decreases as investors become more bullish. As subjective as implied volatility may be, however, it is an extremely accurate measurement of the posture of those who drive the market.