Fear, greed, and the VIX
07/05/18

Since being a hot topic of conversation in late-2017 and early-2018 because of its extreme lows—and, of course, its spike during the February market correction—the Cboe Volatility Index (VIX) has been keeping a fairly low profile. But as recent market action makes clear, it’s an indicator stock traders should keep tabs on even when it’s not making headlines.

The VIX, which is derived from the implied volatility of S&P 500 (SPX) options, is a common gauge of the stock market’s level of fear or complacency. In a nutshell, the higher the VIX, the greater the fear level, and vice versa: Big SPX down moves are often accompanied by sharp VIX up moves (i.e., rising fear), while big SPX up moves are usually mirrored by VIX down moves (declining fear):

S&P 500 (SPX) and Volatility Index (VIX), 9/25/17 – 6/28/18. Inverse relationship

Source: OptionsHouse

Because the SPX and VIX usually move in opposite directions, traders often use the VIX as a contrarian indicator: VIX spikes are seen as indications that investor fear has reached a “capitulation” level that may lead to a market bottom or significant swing low, while sustained VIX lows are typically seen as a sign of investor complacency or overconfidence associated with market tops. (However, as 2017 proved, the VIX can remain at low levels for a very long time before a significant SPX downturn occurs.)

But the VIX doesn’t have to be at a multi-year or even multi-month high or low to provide potentially useful information. Comparing VIX and SPX levels at related points can give clues about market direction: When the two are moving in tandem instead of in the opposite direction, interesting things can happen.

For example, on a day the SPX makes a longer-term (say, 50-day) high and the VIX also rallies (instead of declining), the odds of at least a short-term decline are greater than average (see “When the VIX clicks”). Similarly, lower SPX swing lows that have lower VIX highs (instead of higher highs) can sometimes identify reversal points, the implication being that the “fear” level reflected by the VIX isn’t as extreme as the drop in the index itself (see “VIX watch”). The following chart shows this occurred between February 6–9 (A), March 2–23 (B), March 23–April 2 (C), and April 25–May 3 (D):

S&P 500 (SPX) and Volatility Index (VIX), 1/24/18 – 6/29/18. Comparing SPX lows and VIX highs

Source: OptionsHouse

The opposite condition—a higher SPX swing low accompanied by a higher VIX high—can sometimes be useful, too. For example, on June 25 the SPX made a higher low (and close) relative to the most recent (May 29) swing low while the VIX made a higher high and close (E)—in other words, it registered a higher “fear level” than it did when the SPX was trading higher, which is the opposite of the expected SPX-VIX relationship. After treading water for a day, the SPX closed below the June 25 close on June 27, and traded to a lower low on June 28. Also, note that on June 28 the VIX made a lower high relative to June 25 (F)—a possible signal a market upturn was possible (the SPX did, in fact, trade higher on June 29).

It can’t be stressed enough that every situation is unique—it’s easy to find exceptions to the examples outlined here—but once you know a market (or the relationship between two markets) has an established tendency, it’s a good idea to take notice when it strays from that pattern.

 

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