How can you gauge volatility?
The key to understanding volatility is to acknowledge that it exists and that it cannot be completely avoided. Volatility generally rises ahead of key economic data, political events, or monetary policy decision. As the markets begin to prepare for new information, volatility will rise. The lack of new information can provide a trending market, where volatility declines.
Since its nearly impossible to completely avoid volatility, what is important is that you are cognizant that volatility could be on the horizon and have a plan on how to manage rising volatility.
The first step is to be on the lookout for rising volatility. You can use a chart of historical volatility, as well as analyse option premiums to determine if implied volatility is on the rise. Implied volatility is the estimate of the market of future volatility and is incorporated into option prices.
For example, the VIX volatility index measures the “at the money” strike prices for the S&P 500 Index. This index is a future gauge of volatility for the S&P 500 index. It generally falls when the S&P 500 is trending higherand rises as the S&P 500 begins to fall. In late December of 2018, options traders priced in that the S&P 500 could rise or fall 36% from those current levels. Today, options traders are only pricing in a 12% move.
By using a gauge like the VIX, you can determine if a subset of the market is worried about a potential decline and if prices are likely to trend or become volatile.