In my June 20 Technical Tuesday column, I discussed the Chicago Board of Options Exchange (CBOE) Volatility Index, more commonly known as the VIX. I talked about how the VIX is constructed as well as the history of it. I also described how the VIX can be used by traders and investors to project the anticipated range of the widely followed S&P 500 Index. If you missed that column, or want a refresher, you can view it here…

As I previously mentioned, the real value in the VIX lies in its ability to measure the attitudes of traders and investors. Those attitudes are communicated in the constantly changing VIX readings. And understanding those attitudes — and how they are reflected in the VIX — is the key to using this important volatility metric to improve your odds for achieving financial success in the market.

The two primary emotions that drive market traders and investors are fear and greed. And that’s exactly what the VIX reading conveys. The VIX is an excellent measure of the current level of fear and greed – or, to be a bit more accurate, fear and complacency — in the market. In fact, the VIX is often referred to as the “fear gauge.”

That’s because a high VIX reading is generally associated with there being a great deal of fear among traders and investors. Conversely, low VIX readings are typically considered to be a reflection of a lack of fear in the market, or investor complacency.

Is that true? If you look back at the historical price action of the VIX, you will see that the Index has typically been negatively correlated with the S&P 500. By that I mean a rising VIX has generally occurred during times when the S&P 500 is falling and vice versa.

But wait! If you recall, I said back on June 20 that the CBOE first constructed the VIX in its present form a mere three years ago. What kind of historical perspective could we take from just the last three years?

Not much. Fortunately, however, the CBOE has recreated the VIX going back to January 2, 1990. So, we can actually compare the changes in the VIX with the changes in the S&P 500 over a number of bullish and bearish market cycles. And when you look back at the past 16 ½ years of VIX readings, you will observe an Index that has generally trended in the opposite direction from the S&P 500.

That makes sense when you think about it. There is an increase in the VIX reading when option premiums rise. Rising option premiums are thought to be a reflection of increased fear in the market.

Why is that?  Let me suggest a couple of reasons. First, an expansion in option premiums is a reflection of increased volatility. Increased volatility — or the range which securities trade within — entails increased risk. So, rising option premiums are an indication that traders and investors anticipate the S&P 500 will be trading in a wider range — one that contains a greater degree of risk.

Another reason a rising VIX is considered to reflect increased fear in the market is that put options are used by some investors to hedge their long positions in order to limit their risk in the case of a decline in share prices. For example, let’s say you are an investor and own a portfolio of stocks. But you’re concerned that the market may experience a significant decline over the next few months. However, you don’t want to sell your holdings.

As an alternative, you can purchase some puts on the S&P 500. Assuming that your holdings are sufficiently diversified, those puts will enable you to hedge against the overall market risk you’re forecasting over the near-term. So, if you are correct and the stock market does suffer a decline — and your stocks fall in value as well — the puts you have purchased should have appreciated in value and at least partially offset the loss in your stock portfolio.

Many institutions and mutual funds purchase S&P 500 options to hedge their portfolios as well. That increased demand for options — a result of an increased concern, or fear if you will, about current market conditions — has the effect of increasing the price of the option premiums. That expansion in option premiums is reflected in an increase in the VIX’s value.

So, with a rising VIX reflecting an increase in fear in the market, we should expect a VIX that trends higher should generally correspond with lower stock prices, right? That’s in fact what tends to happen. If you look back at a chart of the S&P 500 and compare it with a chart of the VIX, you will see that the two tend to move opposite one another. Therefore, a rising VIX is a sign of increasing volatility — and a declining market.

But the VIX can provide the astute technical analyst with other valuable information as well. Remember that emotions — fear and greed — are reflected in the price of the VIX. Emotions can have a powerful effect on stock prices — and can peak at market extremes. Well, since those emotions are encapsulated in the price of the VIX, when the VIX reaches an extreme level — relative to its recent price range – you have a signal that the market is overextended in one direction and set to make a turn.

That’s been true when the market has been in a lengthy downtrend — and the VIX is at a significant top. For example, peaks in the VIX in 1990, 1994, 1997, 1998, 2001 and 2002 have coincided with important market lows. And major lows in the VIX have coincided with a number of significant market tops as well.

Therefore, if you think S&P 500 may have reached an extreme level, check to see if the VIX has reached a major peak or trough relative to its recent price trend. If it has, odds are good you have pinpointed a major turning point in the market.

So, next time you think you’ve spotted a major market turn, be sure to check a chart of the VIX. If you find it trading at an extreme, your forecast of a significant trend change could be right on the money. And if you’ve caught the VIX trading at a bearish extreme, you may get to buy those stocks you’ve been watching at just the right time.

Trade well,

Mark Bail
July 11, 2006

The VIX: What It All Means was originally featured in the Penny Sleuth.

With the large gyrations we’ve been witnessing recently in the major stock indexes, there has been a lot of talk in the financial media about “volatility” becoming more a part of the everyday market.  Although it pains me to say it, the purveyors of business news, gossip, and opinions are right this time.  I guess that just validates the “broken clock” and “blind squirrel” theories.

The stock market has, in fact, been subject to a greater degree of volatility in recent weeks.  But how do we measure that volatility, and what are the financial pundits actually referring to?

It’s a metric constructed by the Chicago Board of Options Exchange (CBOE) known as the Volatility Index — or VIX for short.  Just what is the VIX, and what information can be gleaned from its readings?

Let’s begin by considering what the VIX measures and how it’s constructed.  Once you understand that, you will have a better idea of why you’ve been hearing so much talk about this measurement and the implications you can draw from it.

Here is an excerpt from a report on the VIX found on the CBOE website:

“VIX continues to provide a minute-by-minute snapshot of expected stock market volatility over the next 30 calendar days.  This volatility is still calculated in real-time from stock index option prices and is continuously disseminated throughout each trading day.”

Notice the use of the word “continues” in the first sentence.  That’s because the report I just quoted from was prepared in 2003 by the CBOE to introduce a change in the methodology behind the VIX.  I’ll get to that in a minute.

The VIX was originally conceived in 1993 to provide traders and investors with an up-to-the-minute gauge of market volatility.  The VIX measures the amount of volatility contained — at any moment in time — in option premiums.  In its original form, the VIX was constructed by using a weighted average of the implied volatility of the at-the-money and near-the-money options on the S&P 100 index.

The composition of the VIX was changed in 2003.  At that time, the CBOE created a “new” VIX by making two changes to the original version.  First, options on the S&P 500 index were substituted for those on the S&P 100.  The CBOE decided that the S&P 500 — a widely followed average commonly used by mutual funds as a benchmark to judge their performance results — was more representative of “the market” than the S&P 100.

The second change made by the CBOE was to increase the amount of options used in the calculation of the weighted average.  It was thought that by expanding the number of options used to calculate the weighted average, the VIX in its newer form would provide a more accurate representation of the level of implied volatility currently existing among option premiums in the market.

All options used in the VIX calculation are either in the front month — i.e. the nearest month to expiration — or the second month.  The reason the CBOE limits options to the two nearest months is because it is their goal for the VIX to estimate the implied volatility of what an at-the-money option on the S&P 500 would contain with 30 days left until expiration.

The VIX is quoted in terms of a number between 0 and 100 — and normally trades at the far lower end of that range.  For instance, as of the close of trading on Monday, June 19 the VIX was at 17.83.

That number represents the anticipated percentage movement — both up and down — in the S&P 500 index over the next 30 days.  So, for example a VIX reading of 24 would mean that — based upon the implied volatility in the options on the S&P 500 index in the front and the second months — the index is expected to move within a range of 2% (the 24 VIX reading divided by 12 months) over the next 30 days.

So, why is the VIX important?  For one, it provides you with a reasonable projection of the expected range within which the S&P 500 is likely to trade within the next month.  To use the current environment as an example, the S&P 500 closed on June 19 at 1240.14.  The June 19 closing VIX reading of 17.83 suggests that options traders and investors anticipate that between now and July 19, the S&P 500 is likely to trade roughly within 1.49% range (17.83 divided by 12) of 1240.14 — or between 1221.71 and 1258.57.

Now, that doesn’t mean the S&P 500 will actually trade within that range.  Keep in mind that the VIX changes on a minute-by-minute basis, according to the ongoing changes in the implied volatility in the S&P 500’s nearest two months’ option premiums.

Therefore, the VIX — and hence the projection of the S&P 500’s trading range for the next month — is being constantly revised.  Nevertheless, that projection — as gleaned from the latest VIX reading — is an accurate reflection of the attitude of traders and investors about current market conditions.

And that reflection of traders and investors’ attitudes is the heart of the VIX’s value.  When you can correctly gauge market participants’ attitudes — and then use that information to anticipate likely future price action — you have acquired an additional edge in your efforts to make money in stocks.

In my next Technical Tuesday column, I’ll talk about the meaning of specific VIX readings.  More importantly, I’ll discuss how you can use that knowledge to your advantage.

Trade well,

Mark Bail
June 20, 2006

The VIX was originally featured in the Penny Sleuth.