OPTIONSMART MORNING UPDATE: Showed weakness

1. OUTLOOK: Better-than-expected reports on retail sales and consumer sentiment lifted big blue chip stocks, but gains were limited by weakness in technology. Shares of National Semiconductor (NSM) fell Friday, a day after the chip company posted a higher quarterly profit, but also continued to worry analysts about its revenue-growth potential. Yahoo gained after Kaufman Bros. upgraded the Internet giant to buy.The chip sector did get some upbeat news from Gartner Inc., which reported that, while worldwide spending on semiconductor equipment is poised to fall 42.6% this year, it is expected to grow 45.3% in 2010. QQQQ implied volatility slipped further to 52-week lows as large traders continued to dump protective puts. Bullish sentiment prevails.

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2. FEAR GAUGE: QQQQ implied volatility slipped to record lows as recovery fears faded away.  

About Implied Volatility.  Investor fear and greed play a significant role in financial markets. The question is, how can investors measure market sentiment in an emerging market situation? How can they gauge the fear? Volatility is a well-known measure of risk in financial markets. When volatility is low, there is a lack of fear. High volatility, however, suggests a fearful markets. Volatility can be calculated in two ways. Either from historical stock price data or from current option price data. Using the second method results in an implied volatility measure. It is a reflection of fear and greed amongst a wide group of market professionals. It’s not wise to ignore this parameter.

4. Implied volatility (IV) is the most useful market sentiment indicator. Implied volatility is simple to understand but is hard to predict. It changes as investor sentiment changes.  

Implied volatility is a measure of what investors think about future volatility. For example, it reflects what investors "think" about future QQQQ stock movements. Implied volatility will rise when investors are becoming very fearful. This matters to QQQQ option traders because an increase in implied volatility causes a rise in option premiums.  

Generally speaking, implied volatility increases when the market is bearish and decreases when the market is bullish. This is due to the common belief that bearish markets are more risky than bullish markets. Therefore, implied volatility can be used to predict short-term stock price movements.

The scatter diagram below displays daily changes of the NASDAQ-100 index and NASDAQ implied volatility (VXN) for the period: 04/06/09 – 11/30/09.

This diagram suggests a negative correlation between NASDAQ and its implied volatility as the pattern of dots slopes from upper left to lower right. The trend line suggests that a 1% rise in implied volatility corresponds to a 0.2% drop of the NASDAQ index. It is a statistical regularity. However, in daily trading you can expect these two parameters to fluctuate accordingly. For example, if the NASDAQ index plunges but its implied volatility doesn’t surge, in other words, bullish sentiment still prevails, you have a good reason to expect an upswing very soon.

You can find more tips how to use implied volatility in option trading at http://www.optionsmart.com

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