Hello again, Sleuths,

Over the past several months, I’ve devoted several columns to the subject of volatility. As I’ve
previously discussed, volatility is a very useful concept to understand and apply as part of your
overall trading and investing strategies.

Knowledge of volatility can help you assess a market average’s expected short-term trading
range, the overall direction of stocks, and whether a change in the trend is likely at hand. And if
you’re an options trader, or you are a conservative stock investor who sells covered calls or buys
puts as portfolio insurance, an awareness of current volatility levels can alert you to the best
times to either buy or sell options.

In several earlier Technical Tuesday columns, I focused on the Chicago Board Options Exchange
(CBOE) Volatility Index, or the VIX as it’s more commonly referred to. If you missed those
columns, or would like a refresher, you can view them here:

June 20, 2006

July 11, 2006

August 8, 2006

August 22, 2006

September 19, 2006

Now, the VIX is the most widely followed volatility metric in the marketplace. But it’s not the only one.

Today, I wanted to alert you to another volatility measurement. Those of you who are seasoned options traders and/or active practitioners of the art of technical analysis, you may already be familiar with the metric I am about to discuss. If this description fits you, please bear with me.  Perhaps you will find today’s discussion to be a useful reminder.

For the rest of you Sleuthers, the volatility measurement I wanted to bring to your attention is the Chicago Board Options Exchange NASDAQ Volatility Index, or VXN. The VXN was introduced by the CBOE in January 2001.

The CBOE’s purpose in creating the VXN was to offer the trading and investing public a volatility indicator similar to the VIX. The only difference between the VIX and the VXN is that this new indicator was primarily created to measure the volatility in the large technology companies that make up a large portion of the NASDAQ 100 Index. Unlike the VIX, which originally was based upon the options in the S&P 100 Index (OEX) — and now consists of S&P 500 Index (SPX) options — the VXN was created from options on the NASDAQ 100 Index (NDX).

Similar to the modifications it made to the VIX, the CBOE altered the methodology it used to calculate the VXN on September 22, 2003. And just as it did when it adjusted the VIX, the CBOE created a historical price history for reference purposes on the revised VXN, going back to February 2001. If you would like to see the VXN’s price history, it can be found on the CBOE’s website.

So, in its present form, the VXN (just like the VIX) is a volatility gauge constructed from index options taken from either the front month (the month closest to expiration) or the second month. To put it another way, the VXN, similar to the VIX, uses a weighted average of options with an average maturity of 30 days until expiration. However, unlike its tinkering with the VIX, the CBOE continued to base the value of the VXN on options from the same underlying stock index as before, namely the NASDAQ 100.

There are other similarities between the VXN and the VIX as well. Like the VIX, the VXN is also quoted in terms of a number between 0 and 100. And similar to the VIX, the VXN reading is a dynamic representation of expected percentage movement in the NASDAQ 100 Index projecting ahead over the next 30 days based upon the implied volatility in the indexes near the money options within two months of expiration.

OK. So, why am I telling you about the VXN? After all, the VIX is a much more widely followed volatility gauge.

I have three reasons. First, when using different technical indicators, it is always a good idea to obtain confirmation from another technical tool. No matter how much you like or have confidence in one particular tool, your chances of having received a profitable signal are increased when a different indicator points you in the same direction. That’s what’s called confirmation. And your chances of success are greater when you have signals that confirm one another.

To put this in the context of the VIX and VXN, if both gauges are communicating the same information concerning volatility, you should be able to rely upon those readings with a greater degree of confidence. And since the VXN acts just like the VIX, you can use these two measures in combination to analyze the relative overall expensiveness of option premiums, the likely trading ranges of two key market averages, the existence of a clear market trend, and the possibility of a market turning point.

As you would expect, these two indicators tend to move in a similar fashion to each another. But since they are rooted in different indexes, they do not trade exactly alike. So, watching both gauges can give you a broader picture of general market volatility.

My second reason for writing about the VXN today is that I consider both the NASDAQ 100 — and its index cousin, the NASDAQ Composite — to have an inordinate influence on overall stock market conditions. If you look back to the late-1990s, you will see that the NASDAQ 100 and NASDAQ Composite have typically acted as leaders during bull market phases and laggards in bearish ones. So, it’s a good idea to keep tabs on a volatility measure directly derived from one of these important market averages.

Finally, the VXN is useful to follow simply because it doesn’t receive the attention of the more popular VIX. While it’s wise to know what the crowd is watching — and there are many ways to use technical analysis concepts to do just that — it’s also helpful to monitor indicators that aren’t followed so closely by the masses. The VXN is one such gauge.

So, if you use the VIX as part of your approach for analyzing the stock market, pull up a chart of the VXN while you’re at it. After all, two volatility gauges are better than one, right?

Trade well,

Mark Bail

Penny Sleuth Contributor

The Penny Sleuth also features commentary by other financial analysts, small-cap experts, investment gurus and an array of contributors from various fields and occupations. Their diverse insights and contrarian investing ideas are hand selected by the Penny Sleuth editors.

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