INDICATORS
Sentimental ImplicationsMarket 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.
WHY IMPLIED VOLATILITY?
Investors utilize myriad methods to identify and measure levels of market sentiment. These methods fall into two broad categories: technical indicators and surveys.
Technical indicators, such as George Lane's stochastic indicator and J. Welles Wilder's relative strength index (RSI), distill price and volume information through a mathematical filter to remove the noise - erratic volatility - from the market. Technical indicators are appealing because they calculate their results based on objective data.
Surveys are indicators derived from personal responses from active and/or institutional traders to a series of questions. Surveys are more subjective than technical indicators, but they still provide an excellent outlook for the longer-term perceptions of market movers.
...Continued in the March issue of Technical Analysis of STOCKS & COMMODITIES
Excerpted from an article originally published in the March 2005 issue of Technical Analysis of STOCKS & COMMODITIES magazine. All rights reserved. © Copyright 2005, Technical Analysis, Inc.
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