Since our VIX piece last week, several commentators have discussed the volatility index. I wanted to clarify some of the errors, myths and misunderstandings that are generally out there:
1) The VIX is an oscillator, moving between extremes within a trading range. At both extremes, it often foretells short-term market reversals. I’ve found the spikes to highs to be a more reliable predictor of a rally than a drop to a low (VIX spikes upwards tend to be to more extreme, and is easier to separate from the noise). Still, the VIX lows have had predictive value.
2) The VIX trading range differs from era to era. Thus, it is of no value to compare the low from the present range to the low from the previous one. Indeed, in the 90s, the VIX spent most of its time spike in the low single digits and mid teens. A spike to 21 turned out to be a buy signal then.
3) Although the CBOE changed their VIX computation, the data on any chart is still consistent. This only means you must choose: you can look at the new VIX, which reflects volatility on the S&P500, or the old VIX — renamed VXO, which is the volatility of the OEX 100. Regardless of which volatility index you choose, when looking at a chart of either the VXO or the VIX, you are looking a consistent data set for that index.
4) I do not know how to compare the VIX with the VXO; It’s really an Apples to Oranges comparisons. A chart of either one is consistent with itself. If you layover the VIX and the VXO on the same chart, they appear to be nearly identical. Regardless, the same trading rule holds true for either index – at significant extreme readings, it suggests an imminent reversal. Again, the spikes are what matters.
5) Static numbers are meaningless. Since the VIX/VXO is an oscillator, what’s important is a move to either extreme.
“Systems & Forecast’s” Marvin Appel wrote a good description of why a drop in the VIX often foretells a reversal:
To understand why VIX reflects investor confidence, it’s helpful to think of stock options as insurance. The more volatile the market is expected to be, the greater the potential value of option insurance, so the higher the cost of options (all else being equal). Low readings of VIX imply investor complacency, and high readings imply anxiety. When stocks are in an uptrend, many investors do not fear risk and are willing to sell options. (An investor who sells an option is in essence taking money to bear market risk.) The greater supply of option sellers when stocks are rising will tend to drive down option prices (lower VIX).
-Marvin Appel, Systems & Forecasts
“Reading the ‘VIX: How to navigate a complacent market”
2:24 PM ET Oct. 20, 2003
Here’s Appel’s chart of the VIX versus the SPX:
The bottom line: This is a worthwhile indicator than can be used by either traders or investors to faciliate their posture. As we discussed in our analysis of Contrary Indicators, these signals are ideally used in conjunction with other signals or factors. The more evidence (i.e., signals) that line up, the greater confidence I have in making a market call. Its a matter of conviction.
References:
Reading the ‘VIX’ : How to navigate a complacent market
http://cbs.marketwatch.com/news/story.asp?guid=%7BF7EE003B%2D1510%2D4DE1%2DB16E%2D7FD2022A5C0B%7D&siteid=mktw
Are advisers spooking themselves?
http://cbs.marketwatch.com/news/story.asp?siteid=mktw&dist=mktwmore&guid=%7BB4600687%2DE7EE%2D48D6%2DBC24%2D12FBB2078B90%7D
