One of the ways that investors can measure expected volatility is through the CBOE Volatility Index, or VIX, which is also sometimes referred to as “the fear index.”
We have talked about this indicator several times in the past because it is so useful in evaluating investor expectations.
The VIX evaluates option prices on the S&P 500 index for an annualized estimate of how volatile the market is likely to be over the next 30 days.
Because volatility and bearishness are usually related, a low VIX reading is bullish, while a high VIX reading is bearish.
Following the VIX
Over the last three years, the VIX has hit an annual low reading near 10-11, which equates to 30-day volatility expectations of 2.9%-3.2%.
The VIX reached that low this past Tuesday, which on the surface seems pretty bullish. However, this time, the VIX’s decent has been a bit unusual. The decline from the fearful highs following the “Brexit” outcome has been faster than any previous decline over the last 11 years, when measured over daily periods.
CBOE Volatility Index (VIX): Chart source — TradingView
The VIX is sometimes considered a “contrarian” indicator. When it gets “too low,” investors are overconfident, and a decline in the short term is likely. When it gets “too high,” fear is overblown, and the market is likely to rise.
The trick is identifying when the indicator is too high or too low.
There are two ways to judge when the VIX is “too low.” The first is to look for a mismatch between the lows on the VIX and the highs on the S&P 500. Those highs and lows are currently behaving normally, so there isn’t any problem there.
The second method is to look for a mismatch between the VIX and its longer-term counterpart, the CBOE S&P 500 3-Month Volatility Index (VXV). If the VIX is falling a lot faster than the VXV, then traders have disjointed expectations between the next 30 days and the next 90 days, which is usually a bad sign.
Based on the relative movement of short-term and longer-term expected volatility, there are some significant signs of market stress. The last three times this method showed divergence levels this extreme were in December 2014, August 2012 and March 2012. The subsequent declines after those signals ranged from 5%-10%, which were hardly game-changers, but they were definitely valid warning signals.
As we have said before, when the VIX is flashing one or both of its classic warning signals, it’s not a sign that the primary trend is changing. Instead, it should be considered a warning that a correction is likely in the near term.
The timing will never be very precise, but, when the signal is present, traders should keep a relatively balanced short-term exposure to the market.
InvestorPlace advisors John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next trade and get 1 free month today by clicking here.
