This article introduces the definition of Degree of Freedom and why we think it is a good indicator of market regime changes.
We will illustrate it with a study over three distinct market periods: the financial crisis of 2007-08, an example of a market bottom, the 2010 European sovereign debt crisis and the flash crash of May 2010. In each of these examples, the Degree of Freedom appears to be a good indicator of the change in the market dynamics as indicated by the VIX.
Further work still needs to be done, but at a time where alternative indexes are very popular, the Degree of Freedom could be a useful tool to price options on indices without listed options markets. Get in touch, if you are interested to discuss it further.