HOME 

Volatility Index ($VIX)

The index that measures anticipated future volatility, as you might imagine, is called The Volatility Index (also known as “The VIX”). That makes perfect sense (unlike most things when it comes to the stock market). Lately, the VIX has been rising—as it should.

As you probably have observed, markets tend to fall much faster than they rise. And the Volatility Index rises much faster at those times, as well. This occurs because fear is a more powerful emotion than greed and markets move faster to the downside. For that reason, the index is sometimes referred to as the Fear Index, as well.

To illustrate this, consider the experience between the following two situations. Have you ever been in a stock that rises slowly, falls back, and then rises again? If so, what were your thoughts and feelings at the time? Were they of complete confidence and certainty that the stock would move higher? Or were of a “quiet hope” (uncertainty) that the stock would hold that pullback and rise? For most, it was probably a feeling of relief as the latter scenario occurred. This is where the adage “climbing a wall of worry” comes from.

These plodding advances, which are self-correcting in nature, are of lower and declining volatility as the market advances. Now, what about being in the opposite situation of a stock falling like a bag of rocks from a roof top? Were you “certain” about what was happening then? I bet you were! And I bet you were willing to take decisive action, as well. Extreme moves bring about extreme emotion and irrational actions which is reflected in the Volatility Index. Although those actions are irrational, they are decisive but often wrong at extremes. Ever sell at the low? If not, you’re either very lucky or not telling the truth.

The most emotional traders are the ones who are using the most leverage and one of the most leveraged instruments to trade are index options. This is what makes the Volatility Index a useful tool. It is based on the pricing of index options. There are several Volatility indices and for this discussion I will use the index with the symbol $VIX.

Now, fears being stronger than greed for the reasons previously mentioned, traders are willing to pay higher premiums for options to hedge longs and/or attempt to profit during times of a falling market. Since option traders are typically wrong at extremes and willing to pay extremely overvalued option prices, the VIX is an excellent guide to changes in trader sentiment and turning points in the market.

A few years ago the Volatility Index had become a popular indicator. It was focused on by the media almost on a daily basis. Shortly after that focus began, like most things that become the focus of the majority, the VIX began to act in a way most had not seen before. In 2003, the VIX dropped below the levels which had been relatively constant for the prior seven years and then began a steady decline. It had not been below those levels prior to 1996 and those prior year’s low levels signaled a market decline was close at hand.

Typically, the Volatility Index rises as the market falls and it falls as the market rises. This being the case, the popular interpretation of the VIX in 2003 was that it had to rise and the market should fall. But the market had been through a crushing bear market and other market internals were suggesting the bear market had run its course.

What happened was, after a short rise in the market and fall in the Volatility Index to prior lows, the index keep falling and the market keep rising. This brings us to the last few months. The VIX has begun to spike up from historic low levels and we should question what might be the potential meaning of this event.

In the past few weeks, market internals have suggested a short-term bottom in the market, but the price patterns in the indices are not suggesting the same from a long-term point of view. This places the two in conflict and most likely why the market indices are so erratic. In time, the two will come into alignment one way or the other, and we will have a much clearer long-term picture of the future market direction.

The question is: Does this spike up in Volatility Index mean that the market is about to fall like that bag of rocks from a roof top? Not likely! But we do expect to see some increase in volatility in the future. So, if the VIX has seen its lows and will rise, why shouldn’t the market drop since the market typically falls as the VIX rises?

Well, based on the current yield curve (the difference between long-and short-term yields), the odds of a bear market are unlikely. The spread between long-and short-term interest rates is one of the main legs of a bull market and it is still bullish. Of course, corrections always do happen and at times can be severe. But, what about that rising VIX and its correlation with a falling market? A look at the VIX of the past might point us to its and the market’s future movement. ( click here àVIX – S&P500 Charts )

Copyright © 2000-  A-TRADE