This is a more formal follow up to the VIX piece from last week:
Since our VIX discussion last week, market complacency has led to an aggressive sell off. The volatility index has become the subject of several articles, and remains a misunderstood signal. Accordingly, we thought it would be appropriate to clarify a few ideas on the VIX:
1) The VIX is an oscillator, and most of the time, reflects “ordinary” investor sentiment. But when the VIX moves to an extreme reading, that signals acute investor sentiment that is of most value to traders: Intense VIX readings often foretell short-term market reversals.
To better understand the VIX, think of stock options as “insurance.” Greater fear levels make options cost more. “When stocks are in an up trend, many investors do not fear risk and are willing to sell options,” recklessly taking on more market risk. As more options get sold as stocks rise, the lower option prices go – hence, lowering the VIX.
2) History shows that when volatility spikes to high levels, it is a reliable predictor of a rally. While the converse is true – drops to low levels often precede sell offs – it is a more difficult signal to discern. VIX complacency readings are not as extreme as VIX panic spikes. The VIX cannot go below 0, and the VIX upside is theoretically unlimited. The 1987 crash sent the VIX to over 160. It is easier to separate high VIX readings from market “noise” than low VIX readings.
3) Static VIX numbers are meaningless. Since it is an oscillator, the moves to extremes are what are significant to traders. VIX trading ranges differ from era to era. It is of little value to compare the low from the present range to the low from the previous range. Indeed, in the 90s, the VIX spent most of its time in the low single digits and mid teens. A spike to 21 turned out to be a buy signal then.
4) The CBOE changed their VIX computation last month. The new VIX is a measure of volatility of the S&P500, while the old VIX (renamed VXO) measures the volatility of the OEX 100. Either way, when looking at a chart of either VXO or VIX, you are looking a consistent data set for that index.
5) Comparing the VIX to the VXO is a meaningless exercise of Apples vs. Oranges. VIX and the VXO charts appear nearly identical, and the trading rule holds true for each – at extreme levels, it suggests an imminent market reversal.
Regardless of the math, reading VIX signals is as much art as science. Despite that challenge, VIX lows have had a strongly correlated predictive value which was the reason we were willing to go out on a limb and make a market call when the VIX hit 3 year lows last week.