The more I dig into volatility measurements, the more intriguing the journey becomes. There are lots of thoughts on measuring it, mitigating its effects, and even capitalizing on it. But, in fact, there is really no standard definition for volatility in the financial community.

A general definition might be “the measure of variation in the price of a security.” But this is a little too broad to be useful. I just saw it defined as “variation of price over time” and “rate of change of price” and as “change versus a standard or mean.” Perhaps the simplest definition that resonates with me is “the relative rate at which the price of a security moves up and down.” But there are definitely lots of different ways to define this elusive concept. And almost as many ways to measure it.

In our quest to better understand volatility, one logical way to try to get a handle on this idea would be to see how the pros react to expanded price ranges and increasing rates of change. In our previous articles on volatility, we’ve looked at beta and Average True Range (ATR) as measures of volatility. But there are folks who look at volatility and its effect all the time—options traders. Since these folks watch volatility ever so closely (because it has a significant effect on options pricing), understanding how they see volatility should be a useful concept.

A professor from Duke University named Robert E. Whaley thought that tracking option pricing information was a good way to quantify volatility. His paper from 1983 formed the basis for the CBOE Volatility Index or VIX.

VIX has been called a “measure of investor fear,”—when the index is at its highest levels, volatility and investor fear are high.

By the CBOE’s description, VIX is a measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Next week we’ll dig into the details of how VIX is calculated. But for today, I wanted to focus on the current usefulness of VIX. As we have seen, “beta” has a difficult time adapting to market changes because of its time horizon. ATR is much quicker. How about VIX? Let’s look at a chart.

At first glance, we can see in this weekly chart that as ranges increased, VIX expanded significantly. This is a very good first sign. It gave useful information during the range expansion. As you can see from the smaller arrows, VIX has also given some useful indications in the past about high fear levels leading to intermediate market lows.

Next week we’ll look more deeply into VIX, talk about its big change in 2003 and investigate some ways that we can use it that are more useful (and some that are less so!). Until then…

We’re going to take a break from our volatility series to take a closer look at two markets: bonds and gold.

One has reached bubble proportions— with bonds attaining unsustainable price levels. And in the other one, the gold bugs are starting to whisper quite loudly, “I told you so,” perhaps a bit prematurely.

With the FOMC announcing a monstrous rate cut to unchartered levels, the financial markets have entered yet another era of completely unprecedented existence. While the Fed hasn’t shot its last bullet, it certainly needs a microscope to find its remaining ammo.

And with the Fed Funds rate all but disappearing below single digits, bond prices have absolutely exploded. By any measure, they have made an asymptotic move.

Markets can remain overbought for longer than we expect, but the correction in bonds will most certainly be a violent one when it comes.

Gold on a Run, But It’s Far from a Bull

Meanwhile, gold has been on a short-term tear, gaining $100 per ounce in just two trading weeks. While gold’s relationship to the dollar has improved quite a bit over the short run, its climb relative to crude oil has been absolutely dizzying.

A mere six months ago, an ounce of gold would buy a scant 6.6 barrels of crude oil. With oil’s recent plunge and gold’s strengthening price, that ratio has almost tripled! An ounce of gold currently buys 18 barrels of oil – the highest level since early 1999!

So gold’s strength relative to other weakening commodity prices is impressive. And yes, massive amounts of paper money have been printed and more will have to be printed to make good on the non-stop promises made by (most notably) the U.S. government, as well as others around the globe. Fundamentally, gold certainly wins the “most likely to appreciate to new highs never seen before” award. The gold bugs shout it from every blog. But just when it will reach those lofty heights is far from certain. There is one inescapable fact standing in the way of gold’s coronation – gold is decidedly in a bear market! Before you call for my head on a platter, let’s look at the facts (as represented by price).

The classic and purest definition of a downtrend is a market that is making lower highs and lower lows. And clearly gold’s movement fits that definition to a tee over the past nine months.

There are no fewer than three obstacles in the way of gold moving from “having a nice up move in a bear market” to “bullish shiny metal”:

1. It has to make a few closes above the 200 day moving average for the first time since July. The descending 200 MA is not very far away.
2. It needs to break the downtrend line that is currently at ~900.
3. It needs to make a higher high, above the last one set at 938.50.

When we get all of that done, then we can talk about $2,000 gold. Until then, it’s just another bear market with loads of potential.

Driving home from the airport yesterday, I paid $1.84 for a gallon of gas. I felt like I was in a time warp. These are gas prices from back when the Yankees had a good baseball team…

Just a few short months ago (during the summer), gas prices were shaping up to be THE defining issue of the presidential election. Then the credit markets crashed and the health of the broader financial system quickly pushed crude oil and gas prices down and pushed news about the cost of filling a gas tank off the front page.

The drop has been amazing – here is a chart that I really like. The source of the data is the Department of Energy weekly survey. Take note of the time scale for the graph; it is very compressed and shows over 40 years of data. This is important because you’ll see that the incredible gains that took many years to get us up above $4 per gallon were erased in a matter of a few months.

I’m sure very few people are overly sad about the drop in gas prices (and now heating oil prices). In fact, this huge drop has helped ease the pain of the financial woes brought on by the credit crisis.

And oil prices continue to drift lower, with crude oil futures trading as low as $53.66 per barrel – down more than 65% from the July highs.

Last week, we talked about the part that weakening demand and the strengthening dollar have played in the drop in oil prices. But few people have talked about the bubble-like ascent of prices. There a was an oil bubble and its end was like that of any other bubble. Technical and sentiment indicators were screaming, “Overbought! Overbought!” right up to the top.

So, yes, demand and dollar valuations did help drop oil prices – but they only account for a part of the fall. Most of the fall can be explained in this way – when bubbles burst, buyers flee. And prices drop harder and farther than could ever be expected. Next week, we’ll look at some of the technical analysis and sentiment indicators that signaled a bubble.

But for now, the crude oil market is getting very oversold – the pendulum has swung the other way. Here’s a chart that illustrates the point:

The notes in the chart highlight the key points: Momentum indicators are divergent at current price levels, including my favorite Chaikin Oscillator, which shows that money is not flowing out of this instrument as fast as it was a couple of weeks ago. In addition, we’re staying way oversold on the stochastic and volatility is clearly decreasing.

With these things lined up, it’s a tough bet to say there’s a lot of downside left in crude oil in the near to intermediate term time frames. A rounded bottom or a fairly violent spike up would seem quite likely from here.

Tune in next week as we revisit the bubble months.

Until next week…

Great Trading,