By Julia Lee

Crunching the numbers for the Australian market in the last 22 years since the ASX 200 index began is an interesting task. Did you know that the biggest moves up in the Australian market have happened during a bear market? 2008 saw the biggest positive moves for the index but conversely also the most negative ones.

Here’s a graph of the ASX 200 index in 2008:

 

What is volatility?

Volatility measures how much an asset value is likely to change.

The volatility of the market can be measured by a volatility index. In the US, that’s the VIX index. In Australia, there’s the S&P/ASX 200 VIX with code XVI.

What is the S&P ASX 200 VIX index?

The S&P ASX 200 index measures implied volatility, or the level of volatility that traders have priced in for the market. It is based off the option market.

Uncertainty tends to drive option prices higher, since it benefits from greater volatility. In fact, option pricing models, such as the widely used Black-Scholes model, use volatility as a key variable in calculating the fair market price for a given option series.

The XVI is based on the same principle. By taking actual prices for index options over the S&P/ASX 200, and plugging them into the option pricing equation, the index gives a reading of implied volatility. By using options with the right expiry date, the index gives us a reading on forecast volatility for the next 30 days.

The advantage of this approach is that it is based on real options trades with real money, rather than analyst predictions. As we all know, putting money at risk tends to concentrate the mind, so we can be confident that the index reflects traders' best guess at future market movements. It is also a well-established principle that the collective wisdom of markets can provide greater predictive power than the forecasts of individuals.

The disadvantage is that Australia's index options market remains relatively small and illiquid, potentially limiting the accuracy of the forecasts it generates.

Using the S&P/ASX 200 VIX (XVI)

Reading the Aussie XVI is simple: the higher the index, the higher the predicted level of market volatility. Importantly, indices of this kind have a tendency to 'revert to the mean', so that they tend to return to their long-term average over time. As a result, any level above the long-term mean indicates more fear and more volatility, and a level below the mean indicates less.

Generally a low reading on the S&P/ASX 200 VIX has a high correlation with a rising market while a high or rising read on the S&P/ASX 200 VIX has a high correlation with a falling market.

 

S&P/ASX 200 VIX (XVI)

The S&P/ASX 200 VIX (XVI) is sitting at relatively low levels, which is good news for investors. In fact, the Australian share market is hovering around seven-year highs. Be careful if you start to see the XVI start to move higher, because that may signal weakness in the Australian market.