Low Volatility Favors Investors Right Now

by Adam Warner | January 31, 2012 8:05 am

News Flash: The CBOE Volatility Index (CBOE:VIX[1]) has had a pretty severe drop these past few months. By some measures, this is as fast as it has ever declined. In fact, the VIX has pared nearly 2/3 of its “value” in less than four months.

VIX 1 30 300x186 Low Volatility Favors Investors Right Now[2]

I use the term “value” loosely, though, as the VIX is not a stock or a commodity or any sort of hard asset. It’s a statistical calculation — essentially a measure of the price investors will pay for portfolio protection.

The VIX has no fair value, just simply a market value. And right here, right now — investors have placed a lot less value on that protection than they did just a few short months ago.

Is a Low VIX Cause for Celebration … or Alarm?

So what does a low VIX mean for you? Should you worry that other investors are not all that worried any more? Or should you gain extra confidence now that investors appear to be bubbling with confidence?

The answer is probably a bit of both — it depends on your perspective. A lower VIX hurts day and swing traders, as the VIX proxies the expected range of a given trading day.

Here’s a trick to predicting the markets, using the VIX.

A short and simple rule is to divide VIX by 16 to gauge the market’s estimate for a typical day. In other words, a VIX of 16 means the market expects a trading range in the S&P 500 (^SPX[3]) of about 1%, while a VIX of 24 means an expectation of 1.5%, and so on.

Traders prefer larger swings, so clearly those days of early October, when the market priced in 3%, sure worked better than the current backdrop of 1% days.

Don’t Overpay for Protection

What’s more, that’s the market’s expectation. The actual market has not even met those standards; in fact it’s not even close.

The realized volatility in the SPX – that is, the pace at which the SPX is actually moving — has dipped as low as 7 recently. So even at relatively low levels, the VIX already prices in a considerable lift in volatility from the current market.

It may prove correct, but right here and right now, traders and investors are overpaying for protection — even at these seemingly low levels.

A Low VIX Favors Investors

While it’s a bad backdrop for shorter term-traders, a lower VIX provides a nice setup for longer-term investors. Low volatility almost always accompanies a slow-moving uptrend, and that’s exactly what we’ve seen the past few months.

Gaps have gotten less and less frequent, as have large-range days in general. In other words, it’s tough to get shaken out when the shakes are relatively muted.

Even if you use the VIX itself as a contrary indicator, the drop is persistent, but not too abrupt.

Here’s another trick for using the VIX in your trading/investing.

My favorite gauge is comparing the VIX to its 10-day simple moving average. If it gets 20% above (below) the SMA, the VIX is overbought (oversold) and likely overdue to at least stall or decline (increase), while the market itself is likely to reverse its presumed decline (rally).

Well, VIX has dipped so slowly, it has only triggered the aforementioned “20% rule” twice, in early November and early December. And we saw both at much-higher VIX levels. In other words, we’ve seen a pretty orderly dip from the highs.

And remember, it was the highs that were the outlier readings; the VIX averages about 20 over the course of time. So, we’re sitting at more normal levels now than anything else — volatility only seems low relative to the fall explosion!

Endnotes:
  1. VIX: http://studio-5.financialcontent.com/investplace/quote?Symbol=VIX
  2. [Image]: http://investorplace.com/wp-content/uploads/2012/01/VIX-1_30.png
  3. SPX: http://studio-5.financialcontent.com/investplace/quote?Symbol=SPX

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