Global Volatility: What's the Next Leading Market?

|
Includes: SPY, VXX, VXZ
by: Andrew Hart

It doesn't matter if you're a rookie trader or veteran trader, knowing the importance of volatility is crucial in timing markets and improving trade results. The prevailing leader in measuring market volatility is, of course, the CBOE Volatility Index (VIX), which essentially uses implied volatilities of SPX Index options to measure expected volatility in the market. The higher the expected volatility, the more fear enters the market, generally leading to lower prices. It's also used to quantify how much percentage move is expected in the indices over the next 12 months at any given time. For example, the VIX is currently trading at 25 meaning that participants expect the market to move +/-25% in the next 12 months (On October 27, 2008 participants expected 80% move in the following 12 months). All traders should review the VIX routinely - but what other volatility measurements are worth the time to analyze? There's a volatility index for just about any major US index, check out the quick list below:

Various Volatility Indices: DJIA (VXD), NASDAQ (VXN), Russell (RVX), SP100 (VXO), Oil VIX (OVX), FTSE 100, German DAX (VDAX), China (CHIX), India VIX and more...

It's ironic that many of these indices were created near major inflection points, in other words the creation and proliferation of volatility following has marked the bottom (or top) of the respective market. Take for example the Oil VIX, which was released July 2008 some 3 days after crude oil hit all time highs. The India VIX launched in April just weeks after the market hit bottom earlier this year and now there's a China VIX that was released in July 2009 - perhaps a precursor to marking a market top? I guess its poetic justice given that volatility and sentiment analysis is largely contrarian. That aside, there is real value in each volatility index, though some are better than others. In my view, Global Relative Volatility is key - it's similar to the VIX:VXN Ratio that compares SP500 Volatility to NASDAQ Volatility, but comparing different countries' indices.

There are several European and Asian measures of volatility, most recently we've seen the addition of India and China added to the mix. I'm particularly excited about the China VIX (CHIX) simply based on the overwhelming leadership China's market has played in the 2009 recovery. From a relative strength perspective market leaders tend to lead the market up AND down. In recent months, China and India have led the global stock market higher, with the FXI up more than 100% since the October low (compared to SPY, up 33% since its low reached in March - FXI bottomed out in October). In any case, strong evidence suggests that Asian markets have become much stronger in recent years, and that US markets may not be leading, rather following. If this is the case, the China VIX will be helpful for all traders going forward.

To keep things simple, I look at each volatility index from the same perspective and I recommend that you do the same. I use 20 day SMA Bollinger Bands (2 standard deviation) to quantify relative volatility in the respective markets. Let's take a look at four key volatility indices that will provide some insight for short-term price action.

Index VIX

The India VIX, from the NSE, uses a similar calculation to the CBOE VIX and is based on Nifty 50 Index options prices. Since its inception, the India VIX oddly reached a new low around the same time the market bottomed out. Based on this observation the India VIX may not move similar to the traditional VIX, or at least more time is needed to assess its credibility.

That said, to keep things simple the India VIX is currently moving into a downtrend signaling another leg up in the market although somehow based on recent action the India VIX seems to move in unison with the market so the outlook here is a bit mixed. Let's move on to the China VIX for more clarity.

INDIA VIX - Daily Chart

China Volatility Index (CHIX)

Created by AlphaShares LLC and released in July, the 'CHIX' uses similar calculations to the CBOE VIX and has thus far traded in similarity too (inverse to the market). I recommend adding the CHIX to your watchlist for routine surveillance, as it will likely become a useful addition to your market timing analysis.

As of today, the CHIX is in a confirmed uptrend, which signals increasing fear in the market. A similar move on the CBOE VIX would signal a bearish move on the S&P500. Since the confirmed uptrend in the CHIX in late July FXI (China XINHUA 25 INDEX) is flat to marginally lower. This chart is particularly of interest because it disagrees with almost all other volatility measures - it's market bearish, not bullish. If recent history repeats itself, traders can expect the FXI to lead the SP&500 and in this case lower. In other words, fear in Chinese market participants is increasing giving support to increased short-term selling pressure.

CHINESE VOLATILITY INDEX - DAILY

S&P500 Volatility Index (VIX)

Created in 1993 by the Chicago Board of Options Exchange, the VIX is the leading measure of volatility in the US stock market. I recommend the quick read from Bill Luby over at VIX and More on Ten Things Everyone Should Know About the VIX. We follow and analyze the VIX in our nightly Market Commentary distributed to all subscribers as one of our three sentiment gauges. Here's my current analysis of the VIX.

The VIX is trading around the 25 level and is inside the lower quadrant of the Bollinger bands, which defines a downtrend. The cause for increased concern (excluding the CHIX movement) is a contracting Bollinger bands - the upper and lower bands are moving closer to one another creating an environment for large moves in the near future. As of now, the VIX remains bullish; however, two consecutive closes above the center Bollinger (20 day SMA) would signal increased fear leading to a bearish bias on the market. Traders are curious how low the VIX can go in this environment; Moby Waller recently answered this question and is well worth the read.

CBOE VOLATITLITY INDEX (VIX) - DAILY

To round out the globe I find good value in the German DAX Volatility Index (VDAX) too, but for the most part it's highly correlated to the VIX. Note that the VDAX is currently positioned identical to the VIX in that Bollingers are contracting while price action remains in a confirmed downtrend.

German DAX Volatility (VDAX) - Daily

Global Volatility: East vs. West, Who Leads Next?

With the proliferation of volatility indices comes better analysis but also increased visibility in stock market leadership. Since volatility/fear is considered a leading indicator, new 'VIX' Indices will likely help improve your trading. The primary resource in analyzing multiple volatility indices (i.e. VIX vs. CHIX) is being able to time markets more effectively while defining the leaders that fuel those moves. For example, continue to watch the China ETF (NYSEARCA:FXI) versus the S&P500 - the CHIX is currently the only global volatility index showing supporting a market correction. If the markets to see increased selling pressure in the following weeks a strong case could be made for continued market leadership from China. At least for the short-term it will be clear who's leading this market.