From the March 2013 issue of Futures Magazine • Subscribe!

Leveraging the VIX to spot trend changes

Bull markets rise over extended periods because hope builds slowly and cautiously. Bear markets are short because fear can work its way through the marketplace in a relative instant.

Often, traders maintain their bearish positions too long because they aspire to a certain price target that doesn’t get hit because the time frame of the move has run its course. As a result, these traders must cover and give back hard-earned profits. What most traders don’t grasp is that bear markets don’t end at specific price points; they terminate when fear reaches certain levels.

The volatility index, or VIX, is an important indicator of market fear. It is a useful forecaster of near- to intermediate-term moves in equity indexes. It’s a tool that enables the trader to estimate how much momentum may remain for a current leg. There are two paradigms at work with respect to the VIX: The mathematical interpretation for the sophisticated options player and the psychological factor that really drives markets. 

Technically speaking, the VIX is a measure of implied volatility for S&P 500 Index options. It estimates expected stock market volatility over the next 30 days. It is calculated by the Chicago Board Options Exchange and is derived from a public domain, yet complex, formula that is expressed on a percentage basis.

Reading the VIX

In simple terms, the VIX reading refers to the annualized value of the expected move over the next 30 days. For example, a VIX of 17% projects the market will move 17%/(square root of 12) = 4.9% over the next month. Likewise, a VIX of 40% projects the market to move 40%/(square root of 12) = 11.5%. This is a linear interpretation. Keep in mind that markets tend to move in decidedly non-linear fashion, especially when you least expect it.

In practice, however, the specific forecast of the VIX is not important. Instead, the current reading with respect to both long- and short-term relative values is key. Simply, a low VIX translates into less movement over the next 30 days, while a high VIX means a larger percentage move. But keep in mind, the reading is direction neutral. 

That said, there is a psychological factor at play. For traders, analysts and the financial media, high volatility connotes a market drop, while low volatility implies a rising market. In addition, many believe a low VIX reading means more of the same, while a high VIX reading means the market is poised to shift. 

But this conventional wisdom isn’t necessarily correct. For instance, in 2002 when the S&P 500 bottomed at 768, the VIX high was approximately 42% that week, but fell to 36% the day the market turned. Technically speaking, traders could have anticipated an approximate 10%-12% move over the next 30 days. Further, traders following mainstream assumptions may have assumed the market would be lower over the next month. However, the low to high over the next 30 calendar days was 768 to 894, a difference of 16.4%. 

The opposite move higher is not such a stretch; when markets truly do bottom, everyone thinks prices are going down forever. However, the right approach is to buy when there is blood in the streets, expecting prices to rise as a result of all buying pressure having been extinguished. A similar misconception also is rampant on the upside. Traders who enter in a late-stage bull market are not psychologically ready for the turn; the most important number to them is not the VIX, but rather how much skin they have in the game. 

Consider the true cost of improperly analyzing the VIX. With respect to the 2002 move, instead of a 12% drop, we saw a 16.4% rise; this is really a 28% mistake. Approaching the VIX correctly is critical to market survival.

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