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WHAT HAVE OPTIONS GOT TO DO WITH IT?

An option is simply the right – but not the obligation – to buy (a ‘call’) or sell (a ‘put’) something.

They are more valuable the longer you have that right (because the market has longer to move in your favour) and the more volatile the market is – because the more the market swings about, the greater the potential gain.

In January we talked about the twin headwinds that could cause trouble for the Australian share market – slowing Chinese growth and rising U.S. interest rates – so we weren’t surprised to see the market fall 6.6% over the March quarter (specifically, the ASX 200: the benchmark index including the top 200 companies).

We also suggested that “investors should brace themselves for more volatility.” In fact, volatility has only been around average levels so far this year, and ended the quarter at relatively low levels.

That may be about to change, but before we tell you why, we should take a moment to explain what volatility is, and why it matters.

In a general sense, volatility is just the degree to which the market bounces around. High volatility means big day-to-day or week-to-week swings. A low volatility market may be going nowhere, or it could be steadily rising – or falling.

The standard measure of volatility for the Australian share market is the ASX200 VIX Index and the crucial thing to understand, is that it’s not a measure how much the market has been bouncing around. It’s a measure of expectations.

The index calculates volatility from the price of option contracts over the ASX200 share index, so it reflects expected equity market volatility over the next 30 days. It is often used, therefore, as a measure of short term nervousness in the market. It’s no surprise then, that a rise in the VIX index is associated with concerns about what the market may do over the next 30 days.

In other words it’s a handy glimpse into the minds of investors and traders, and is often called “the fear index”, which is why the 8 year peak was reached at the start of the GFC (Global Financial Crisis).

So what is volatility telling us at the moment? At the end of March the ASX200 VIX stood at 16.3. To understand what that means, we need to put it in perspective.

The ASX 200 VIX Index

“Now”(ish) 31st March  16.3
Long term (8 year) average since Jan 2008 21.0
Long term excluding the GFC since Jan 2010 17.1
High during the GFC Nov 2008 66.7
8 year low July 2014 9.3

So the level at the end of the quarter is below average but not anywhere near as low as it can go. Actually it’s recent low was 14.0 on 22nd March, since when it has climbed to 17.7 on 7th April.

Why might volatility be about to rise further?

Investor nervousness is triggered by uncertainty.

  1. Changing rhetoric from the Federal Reserve in the US. The Fed has surprised markets over the last couple of weeks with concerns that falling commodity prices and sluggish global growth abroad could slow the US economic recovery.
  2. An appreciating Australian dollar. The Reserve Bank of Australia has expressed concerns about the impact of the stronger Australian dollar: “Under present circumstances, an appreciating exchange rate could complicate the adjustment under way in the economy.”
  3. An election in Australia. Markets never like the uncertainty that comes from an election.
  4. An election in The US. Ditto, particularly when the race is close and the candidates are so polarized.
  5. A referendum in the UK, about European Union membership: ditto again because this referendum could cause more uncertainty (certainly for Europe) than a regular election.

If investor nervousness does rise, expect it to be accompanied by falling prices. Of course, for long term investors this may represent an opportunity. The MoneyTalk Sharemarket Pendulum is swinging back toward the year’s low – towards buying territory for the brave…

share pendulum7Apr16

What are your thoughts?

Do you think the market is looking shaky? Join the conversation — leave a comment below and let us know what you’re thoughts are.