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Sunday, November 28, 2010

Fair Volatility Estimate Indicator - Revisited

- Fair Volatility Estimate (FVE) indicator is my own creation, and I believe with it, I could contribute much to the study of markets, of volatility, and of technical analysis. But I am yet unsure of its potential because FVE was developed just this summer. I have been observing FVE Indicator's signals and commenting about the market for the past few months. So far, my observations based on FVE has been very accurate. Of all the technical indicators I use to gauge market energy and it's ever changing flow, FVE is the most valuable and unique.

-I have searched the internet to see if there were other indicators like FVE. VIX is the most similar, but VIX is calculated from options prices on the S&P500 index. FVE is very similar to VIX in that it mirrors VIX (0.988 correlation, variance on FVE 5.29, while variance on VIX is 5.72 for data Jan-Sep 2010), but FVE is calculated from the price of the underlying (SPY in this instance), and not the price of its derivative.

- Why is this relevant? First of all, I would like to think that the FVE could be used as a simple, alternative way to measure appropriate implied volatility (IV) level of options, specifically, at-the-money IV of SPY options. Implied volatility can be described as the expectation of future realized volatility of the underlying by the options market. Well, if everything is already reflected in the Price of the underlying (as technical analysis assumes), why couldn't we estimate the future volatility of the underlying from the underlying market itself? I believe technical analysis adds great value, but technical analysts don't pay enough attention to the importance of volatility. On the other hand, mentioning technical analysis to vol traders would make you instantly lose credibility. Why such divide? I believe that there is value in technical analysis, in volatility analysis, and in technical analysis of volatility.

- FVE offers three general trading rules:

1) for directional or delta traders, when FVE is above/below its moving average, look to go short/long delta, especially when FVE's value has reached around its highest/lowest levels.

2) for gamma (options) traders, when FVE is rising/falling and above/below its moving average, look to go long/short gamma, and even vega especially when FVE's value has reached around its highest/lowest levels.

3) for options market makers, when implied volatility of SPY at-the-money options are significantly above/below (greater than 2-3 points) be better seller/buyer of options.

Examples of trading strategy 3 is on 11/1 ahead of elections and Fed meeting, implied volatility on SPY at-the-money options reached 21, but FVE indicator's value was 17.1. This was a good time to sell options and indeed, IV levels plunged the next few days to below 16. Also, on 11/24, implied volatility of SPY atm options were 16.3, while FVE indicator's value was 19.2. This was a good time to buy options, and on Friday 11/26, implied volatility of SPY atm options soared to 19.3.

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