The VIX: What It All Means

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Jul 11th, 2006 | By | Category: Investing Strategies, Macroeconomics

Hello again, Sleuths,

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

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