Why bother with the CBOE Volatility Index — known as the VIX, or the “fear index” — when the S&P tells you more or less the same information?

When the VIX rises, it usually means investors are expecting a wild downswing in the market. When the VIX falls, it means the opposite — that traders are expecting a less-volatile bull trend. But you have to dig below the daily index numbers to look for more subtle changes.

Two specific signals to look for are divergences and rising contango.

Divergences

Click to Enlarge The VIX moves inverse to the S&P 500, but those moves are not always proportional.

For example, if stocks are making higher highs but the VIX isn’t making lower lows, then we have a signal that the bullish trend in stocks is unstable. This indicates that stocks are becoming more bullish, but investor sentiment is starting to top out. This kind of divergence can be subtle, but it provides a powerful warning about the current trend.

In August and September, the VIX formed a series of higher lows (indicating waning bullishness) while stocks formed higher highs. This is a strong signal for traders to tread lightly and carefully into bullish positions — and that a downside breakout is possible in the near-term. In fact, we saw a very similar pattern last year just before the market crash in August 2011.

Divergences are rare, but they tell us a lot about investor confidence (or the lack thereof). At this point, it seems we are in a short-term bearish cycle.

Contango

The VIX is an index and cannot be traded on its own. However, investors can buy or short VIX futures to hedge portfolio volatility.

In many cases, futures contracts with longer expirations will tend to have a higher price than shorter expirations. We call that difference “contango,” and it is a normal condition for the VIX futures.

Once in a while, however, the longer-term futures prices rise much faster than the current VIX’s value. When contango grows quickly like this, it tells us that investors are becoming more fearful about the future and are potentially pricing in a decline. Conversely, when the difference between the price of long-term VIX futures and the current VIX starts to shrink, we assume that investors are more confident about the future and not as fearful about the next few months.

You don’t need to have access to futures prices to see this relationship between the short-term VIX and longer-term estimates of volatility. We can use the VIX index itself for short-term expectations and the CBOE S&P 500 3-Month Volatility Index as a proxy for longer-term expectations.

As its name suggests, the 3-Month Volatility Index measures volatility expectations three months into the future. It is not as well-known as the VIX, but can actually add a lot of clarity to our VIX analysis. You can see a chart of the VXV (black), S&P 500 (candles) and the relative performance between the VXV and the VIX (red) in the nearby chart.

Click to Enlarge In this chart, you can see that the growth of long-term volatility expectations outpaced short-term expectations and spiked on March 15 and Aug. 17 this year. If you exclude the effect of QE3 in September, both of those dates defined a top in the market.

Currently, longer-term expectations for volatility have cooled off, and the contango relationship is near the lows established in May.

We see this as an encouraging sign for the next quarter. Market fundamentals are very weak, and as mentioned, we’re expecting short-term bearishness due to the divergence. But traders just don’t seem interested in pricing in much potential downside — yet.

While this is not a guarantee of a rally, it does create an environment where good news can lead to large positive surprises. We will continue to watch this relationship in the short term, but for now it seems to justify a cautious, but neutral, bias.

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.