Reading the VIX: What the 'Fear Index' Is Saying Now

Stock trader ponders volatile market"When the VIX is high, it's time to buy. When the VIX is low, it's time to go."

That Wall Street truism led to my April 25 report that suggested the extreme low in the VIX index ($VIX) might be signaling a top in stocks. While the VIX didn't "ring a bell at the top," the market did roll over within a week and begin a long decline to its July lows.

Those who sold speculative positions in late April when the VIX was low and bought back in late June when the VIX spiked up (and the market hit bottom) were rewarded for paying attention to the VIX.

Why is the VIX a staple of Wall Street traders? The VIX is the Chicago Board Options Exchange's (CBOE) Volatility Index, and it measures the volatility of S&P 500 index options. When the demand for puts -- options that rise in value if the market falls -- rises sharply, that's a reflection of fear or uncertainty. Hence, the VIX's nickname as "the fear index."

Is the News Expected or a Surprise?

One way to interpret the VIX is to view the market as a discounting mechanism. When all the good news is reflected in the market price, then the market is set up to respond with surprise and uncertainty to unexpected bad news.

When the market has absorbed all the bad news, in effect discounting it by dropping to lows, then it's set up to be surprised by unexpectedly good news.

In late April, the bad news about the Eurozone's sovereign debt issues was discounted. The market reflected a general confidence that the situation was under control, and the VIX remained subdued. When it became clear that Greek debts were a potentially major problem to Eurozone banks and financial stability, this "unexpected bad news" sent the VIX skyward and made the markets tumble.

Let's look at a current chart of the VIX and see what insights it offers. The chart may look cluttered, but we'll examine each piece separately.



What pops out of this chart first is the big spike up in May as the U.S. stock market grasped the deeply negative consequences of the European sovereign debt crisis. When news spooks the market, the VIX tends to "gap up," that is, open much higher than its level on the previous day. I've drawn rectangles around the big gap-ups.

Note the big gaps that opened up as the Eurozone banking crisis exploded in late April and May. But since topping out in mid-May, ensuing gap-ups have reversed in two or three days. Rather than announce the beginning of a new trend, these are classic spikes of sudden jitters that quickly dissipate.

Becoming Comfortably Numb?

Despite a steady drumbeat of negative economic news, the VIX has been in a downtrend since mid-May. Sharp drops in the stock market have not sent the VIX into the same nosebleed territory it reached in mid-May. It's as if the market drops that have been occurring with great frequency in the past few months no longer elicit much fear.

This suggests that either the market is becoming numb to "negative surprises" or that bad news is now "old news." Whatever the explanation, the VIX has been sliding even as the economic news continues to be unsettling.

Since June, the VIX's spikes have followed a specific pattern: Some bit of news sends the market into a tizzy of doubt and fear, and the VIX gaps up. But two or three days later, the index reverses course and drops back into its gradual downtrend.

Bollinger Bands offer another charting tool to assess market volatility and extremes of sentiment. In late June, the VIX leaped up to the upper Bollinger Band, signifying an extreme of volatility. That spike tracked the market bottom: "When the VIX is high, it's time to buy."

The VIX gapped up strongly on Aug. 11, and then broke through the upper Bollinger Band. If this is a repeat of the June and July pattern, it would signify a buying opportunity. On the other hand, if the VIX doesn't quickly reverse course and drop back down to its lows within a few days, then it might be the harbinger of a new trend: up in the VIX and down in the stock market.

Ready to Enter New Territory?

For clues, we can look at the recent highs in the VIX. Did this latest spike of fear exceed the highs of July? No, it reached the same level, around 27. That suggests the current uncertainty is roughly equivalent to the levels experienced in the last month.

But some evidence also hints that the VIX might be signaling a longer-term trend change. The spike up this week has broken the downtrend since May, and the trend indicators of MACD (moving average convergence-divergence) and stochastics are turned upward.

Put all this together, and it suggests that if the VIX falls back to the low 20s early next week, the market has absorbed and discounted the latest "bad news" as not very surprising or very important. But if the VIX remains stubbornly high, or gaps even higher, that would suggest the market perceives greater risk ahead. That would not be a buy signal, but rather a warning light of caution.

The VIX isn't a perfect indicator that rings a bell at the top or bottom, but it does reflect extremes of sentiment that tend to mark tops and bottoms, and general trends of market sentiment. Both are useful bits of information to investors and traders alike.

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fja1950

An Excellent article. Moral of the story is TO BE A PROFITABLE INVESTOR, LEARN TO PLAY BOTH SIDES OF THE MARKET.IF YOU ONLY KNOW HOW TO PLAY WHEN THE MARKET IS GOING UP THEN I AM AFRAID YOU ARE A SITTING DUCK.ALSO HAVE INVESTMENT RULES. THE BIG BOYS HAVE RULES,KNOW WHEN TO GET IN, KNOW WHEN TO GET OUT.KEEP YOUR LOSSES VERY SMALL AND READ A LOT. OTHERWISE PARK YOUR MONEY IN CASH AND EARN 0.4% INTEREST PER YEAR FROM YOUR BANK.

August 16 2010 at 9:21 PM Report abuse rate up rate down Reply
Ray

This is what I am talking about. The stock market if for crazy people trading day in and day out...Not for buy and hold retail investors. Unless you "play" this whoring market, stay away. Don't buy into dollar cost averaging and all the bull crap you are fed. Be forwarned!

August 15 2010 at 10:44 PM Report abuse rate up rate down Reply
kluj1

The vix is just another tool. One should not rely on the vix readings alone. Especially since it is now being watcged by so many people and making headlines such as this one.

August 15 2010 at 7:38 PM Report abuse rate up rate down Reply
dajt666

there will be no correction untill we see traders jumping out windows like in the 20's.

August 15 2010 at 6:08 PM Report abuse rate up rate down Reply
ronsjigslures123

I really hope i live long enough to see wall street fall apart, then this country will build back to a strong country. Andrew Jackson was a lousy Indian killer but one thing he could see that was bad for this young country the centeral bank and the stock sellers,he fought both to NOT be formed, he lost. Wall street has distroyed millions of working peoples lives over the years, and distroyed good elections, and don,t foreget keep wars going to feed there investors but taking thousands of young peoples lives, Viet-nam war was a big one. If the stock market and all these contrll freeks would go away tomorrow this country would go back to work, open thousands of small bussiness, build farms again, and be a productive country again that has some PRIDE. Wall street is nothing but a bunch of EASY money people that have the country,constitution and the peoples good interest at heat, there ALL outright money grabbing greedy crooks that distroy the American way , hard work, family,s and a good life. Im not a Bible person but if they were around back then religion would call them the devil for sure.

August 15 2010 at 3:46 PM Report abuse +4 rate up rate down Reply
tomgold125

The bigger problem we have is the regime that's in power right now. He's
spending a lot of money right now to buy votes. But come january he's got
some big surprises for people. A lot of people that voted for him are going
to be angry. Obama's right on schedule with his fascist agenda.

August 15 2010 at 1:59 PM Report abuse +3 rate up rate down Reply
oredrag

WOW! Our great country and it's strong people(we're talking Main Street here!), you know? The one's that BUILT this country, unlike the stock market! BigBiz develops a wall street series of smoke and mirror schemes to validate their existence? Is this a derivative of some sort? Fear index? Do we rely on wall street to run our country instead of Main Street and it's people? Idiots like Palin that lie and don't tell the whole story about the mosque near the 911 site? Look closer if she says something about it! The old Goober blame game again!

August 15 2010 at 1:10 PM Report abuse +2 rate up rate down Reply
sfamilyent

I find these articles to be interesting, and I understand that regardless of all of the technical analysis the future performance of the markets is not predictable. There is some apparent correlation of global economic news, market direction and volatility direction that a short term investor might use to influence buy and sell decisions.

August 15 2010 at 12:56 PM Report abuse rate up rate down Reply
1 reply to sfamilyent's comment
mobnana

banks and investment firms buy big and the market is said to be going great. then they sucker you in --- to buying your dinnky amount of shares, to push it up a little further. then the big banks and investment firms sell big time, saying it is poor labor outlook etc.etc., but what they are really doing is just taking the profit for them selves! it has nothing to do with fear or jobs!!! you loose again sucker! these three credit reporting houses are the same. its all in who you know on the inside --- the goverment should have never bailed these greedy bank out. and should let them go bankrupt

August 15 2010 at 4:32 PM Report abuse +1 rate up rate down Reply
lenders1

Mspeebles please read your post 100 hundred times, and then maybe.. you may see what you are not saying!!

mpeebles2004
11:28 AM Aug 15, 2010
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I would like to see someone comment on the announcement that several billiionaires will be giving a substantial amount of their wealth to charity. This concerns me because that money would be better spent investing in the economy and creating jobs. That money as charity will have a temporary effect. By putting it back into the economy and creating jobs with it, the impact can be permanent. I have only seen this action praised, but I would like to see someone address the issue. Charity instead of jobs is the wrong message.

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August 15 2010 at 12:53 PM Report abuse +2 rate up rate down Reply
lenders1

Its like the vapor rub. When you smell it, pay attention to it.

August 15 2010 at 12:51 PM Report abuse +1 rate up rate down Reply