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Newsletter: VIX Indicator

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VIX Indicator:

$VIX Volatility Index (a.k.a. the Wall Street's market fear gauge): The new VIX (see footnote below), which came into effect September 22, 2003 is now calculated using the implied values of S&P 500 ($SPX) options. The VIX index is a measure of “implied volatility” on those options – the volatility being implied by the close-to-the-money options on the S&P 500 index. It uses a larger range of options that are weighted to provide a more accurate measure of implied volatility. The time to expiration for these model options is still 30 days. Overall, the change should not have much of an impact on how you use the VIX.

Simply stated, expensive options indicate high levels of fear, and inexpensive options indicate complacency.

A spike in the VIX often occurs near major market bottoms. As the market recovers and investor fear subsides, VIX levels tend to fall, suggesting an overly optimistic market susceptible to setbacks.

Some traders consider a rise in VIX from low levels as a warning sign and a reason to exercise caution when establishing bullish trades. As it creeps higher, the path of least resistance for the stock market is to the downside.

A low index says that investor complacency has risen.

The VIX is a sentiment indicator. When option premiums are high, market technicians view that as an indication of a change in direction, as in the topping process of a bull market.

Traders see it as time to go (sell) when the VIX is low, and time to buy when it's high.

When the “dumb money” is predominantly complacent and bullish, this is often the case prior to a volatile move to the downside in the stock market. The first obvious sign of bullish sentiment would be an on-going drop in the CBOE Volatility Index ($VIX). Such a drop in the so-called “fear gauge” is a sign of complacency among investors and a high level of bullishness.

As the stock market moves higher, and the CBOE Market Volatility “Fear” Index ($VIX) continues to decline, this has to provide some worry over being in bullish strategies. If the VIX has been at a low level for several months, with an occasional spike higher on profit taking, this is indicative of traders continuing to show less and less fear of a market decline (hence, more bullishness), and it raises the odds that one will occur when you least expect it.

Investors will pay high prices for options under fear of a swift market decline. The VIX goes up accordingly. Generally, when the VIX is high, there is a lot of fear in the markets, and that occurs when stocks are bottoming out; hence, “it’s time to buy,” or time to be bullish. This, of course, occurs when the majority is bearish.

The opposite is also true. When market participants feel complacent, and that there is nothing out in the horizon that can send stocks lower, the markets tend to be at some important peak. Additionally, the fact that traders are not forced to hedge their portfolios with expensive puts forces market makers to lower the price of options to move the product. As a result, the value of the VIX goes down; hence, “it’s time to go” (sell stocks).

If you look at an SPX/VIX overlay weekly chart (the S&P 500 being a good market proxy, since it is the best broad measurement of the U.S. markets), you will observe that the VIX consistently identifies the levels of fear and complacency needed to create temporary tops and bottoms and, in the process, throws off some quite reliable market turning points. However, you should not take buy and sell signals off of this indicator alone.

Usually when options players are extremely inactive, that’s a good thing. That’s frequently a good time to buy stock.

Footnote: The old VIX (the CBOE's market volatility index) used a series of options from the Standard & Poor's 100 index as a gauge of market volatility. Today, the symbol for the volatility index on the S&P 100 is $VXO, but you should adopt the "new" VIX ($VIX) as your primary market volatility indicator.

The index itself, and the options it was using, didn't truly reflect market sentiment and volatility prior to the change. The new VIX uses the S&P 500 and the underlying options to measure sentiment and volatility. The old VIX used only at-the-money options to calculate the average implied volatility of the series, whereas the new VIX uses at-the-money and out-of-the-money options. As a result, you'd see that volatility was higher on average than today's VIX, if you looked at an older chart of the VIX.

The mantra among traders remains the same, even though the VIX has changed: "When the VIX is low, it's time to go; when the VIX is high, it's time to buy." You can pretty much continue to use your old benchmarks as signals to go short or long, as the new VIX relative highs and lows vary only by a point or two from the old one.

In the options market, anxiety levels mount, as the CBOE Volatility Index ($VIX), the market's "fear gauge," rises. However, traders may not have panicked quite yet if they are in fact favoring calls over puts. If the number of calls traded exceeds the number of puts, judging by that activity, this would tend to indicate that many options traders are simply using current weakness to establish bullish positions, in anticipation that a recent decline represented a momentary pause in an otherwise bullish trend.

To analyze the level of calls traded in relation to puts, you can use the put/call ratio. For more on that indicator, please click here: commodity trading rules, currency trading strategy, and stock market successful trading strategies

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