The S&P 500 topped on Jan. 4 of last year, which was just the second trading day of 2022. Since then, the S&P has entered a painful decline as growth investors got wiped out and tech stocks plunged into a painful downtrend. However, the VIX hasn’t done what many investors thought it would do. In fact, it has been in a massive lull.
Known as the “Fear Gauge,” the CBOE Volatility Index tends to spike during big declines in the S&P 500. Conversely, it tends to fall when the S&P rises. That’s known as an “inverse relationship,” although it’s not that way all the time and it’s not a one-to-one correlation.
On Thursday, investors are seeing the VIX down close to 10% despite just a mild rally in the SPDR S&P 500 ETF Trust (NYSEARCA:SPY). That has investors wondering what to make of the action.
First, though, investors must realize that the VIX is not a fail-proof indicator. It’s something to monitor and keep an eye on, but it should be used alongside a handful of other observations as well.
For instance, the VIX topped on Jan. 24, 2022, just weeks after the S&P 500 topped out. However, just because the VIX topped almost a year ago doesn’t mean the S&P 500 has been rallying. In fact, the index didn’t bottom until Oct. 13.
Here’s What the VIX Actually Does
Too many investors think that the VIX is a just fear gauge. It’s called that because of how it prices in potential volatility, but it’s not an actual survey of sentiment. According to the CBOE:
“The VIX Index measures the level of expected volatility of the S&P 500 Index over the next 30 days that is implied in the bid/ask quotations of SPX options. Thus, the VIX Index is a forward looking measure, in contrast to realized (or actual) volatility, which measures the variability of historical (or known) prices.”
In other words, “the VIX Index is intended to provide an instantaneous measure of how much the market thinks the S&P 500 Index will fluctuate in the 30 days from the time of each tick of the VIX Index.”
That being said, when fear on Wall Street starts to spread, so do a magnitude of other measures. If trading ranges and spreads widen, the VIX tends to rally and traders pile into hedges and put options.
Some investors will try to use the VIX as a trading indicator as well. For instance, the VIX is now within pennies of the Dec. 2 low, which was $18.95. The Aug. 12 low came at $19.12. The prior two occurrences where the VIX low came into play at near $19 were precursors to the S&P 500 topping out shortly afterwards.
Will it go three-for-three? On this measure alone, it’s impossible to say. However, with a VIX at, near or above $20, investors should always remain a bit guarded and defensive. That said, if it can roll over further from here, bulls may enjoy a prolonged rally.
On the date of publication, Bret Kenwell did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
