We have been getting a lot of questions about the CBOE Volatility Index (CBOE:VIX) these days as it hovers at multi-year lows. Is that a bad thing? Does that mean that traders are over-confident and the market is due for a correction? The answer to both questions is that all by itself, the VIX is not really giving us a lot of new information. The VIX can stay low for quite a while and often does in a strong bull market.
However, if we look just a little deeper beyond the day-to-day index value, there is some useful information coming from the VIX that should make a difference in our trading. Right now, we are watching for changes in two areas – short-term expected volatility and long term versus short term expectations. These are important concepts to understand because it will affect how we select trades and how long we want to hold them.
Short-Term Expected Volatility
Click to EnlargeThe VIX itself is a complicated calculation but it is essentially an annualized estimate of price volatility for the S&P 500 over the next 30 days. If the VIX is currently at 13.96, then traders expect volatility of +/- 4% (13.96%/ √ 12 =4%) over the next 30 days. However, it is really important to understand that this expectation is not for at least 4% or exactly 4% but that volatility won’t be more than 4%. You can see this range in the chart at right.
As you can see, the lower bound right now is roughly equal to support based on September’s highs. As long as expected volatility stays at that level or very near to it, we shouldn’t anticipate a major change to the trend. Could stocks correct a little? Sure, but it’s not likely to change the major trend. Therefore, bearish opportunities should be evaluated very carefully and bullish trades on support bounces should be the priority.
Long-Term Versus Short-Term Volatility
The VIX has a longer-term cousin known as the S&P 500 3-Month Volatility Index (CBOE:VXV)that measures annualized volatility expectations 90 days in the future. The VXV and VIX will be highly correlated but the rate of change between the two will vary. For example, during December the two indexes were nearly equal, which is generally a very bullish sign. We saw that bullishness materialize in January – making this one of the best Januaries on record. However, when the difference between the two grows extreme, we see that as a very bearish signal.
Click to Enlarge We do need to watch that relationship because it can alert us to the risk of sudden shifts in investor sentiment to the downside. In the chart, you can see the VIX (red and green) versus the VXV (black and white) and a relative strength comparison between the two (red line) – this chart can be used to evaluate the risk of sudden changes in sentiment.
The graph basically shows when short-term expectations became overconfident compared to longer-term estimates. Little spikes in the relative strength graph to the downside in March and August last year accurately predicted a downturn in the market. Recently, we saw a decline in that indicator that was similar but not quite as severe. We aren’t too worried about it yet, but a break of the trendline we have drawn here would likely be a signal that investors are nervous. In the meantime, the upward trend of this indicator is a confirmation of a relatively bullish market.
John Jagerson and S. Wade Hansen 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.