The VIX is short for “Volatility Index” and it is designed to measure volatility in the stock market. The Chicago Board of Options Exchange–known as the CBOE–calculates this index and it is based on the implied volatility of selected options of stocks in the S&P 500.
The value of the VIX is inversely correlated to the stock market. When the stock market goes up VIX goes down and vice versa. As we know that stock market moves upward in slow stable manner. Whereas stock market falls very fast and becomes volatile. Therefore, when stock market is rising gradually VIX tends to fall slowly, whereas when stock market starts falling VIX suddenly spikes higher and then keep moving up.
Therefore, VIX can also be considered as “Fear Index”. This is because when stock market is rising upward there is little or no fear among traders/investors and they are calm and optimist about the future thus no fear of losing money. Whereas when stock market is falling the fear sets in and VIX spikes higher.
So one may ask what is the low and high value of VIX. Usually a value in the range of 20-15 is considered low for VIX. And value of above 25-30 is considered higher. Back in October 2008, during financial crisis, VIX spiked to even 90, whereas VIX before 2008 peaked at 45.
Therefore, as a investor you like to have a market which is rising upward and VIX is either gradually moving lower or stable.
On Friday August 17th, 2012 VIX closed at 13.45 which is very low reading for the VIX and one can argue that when “VIX is low it is time to go”, not really. In the past on several occasions when VIX dropped below 15 S&P put on a short-term top. Is it going to happen again in coming days?
Well, we can also argue from other point of view. Does market always put the top when VIX reading is low? What about the argument that when VIX is low the stock market is stable and there is no fear and therefore, low reading of VIX is good for stock market. If we look at the VIX history we will find that in 1990s VIX remained below 15 and remained there for a good period and S&P rallied 48%. During 2004 – 2006 VIX was below 15 and S&P rose about 28%.
Therefore, we can say that relying solely on VIX is misleading. If investors decide to stay away from the market just because VIX is low and they are expecting spike up in the VIX, thus market to fall, then they can miss out on the major rally in the market.
A strong rising market does not suddenly turn south, rather it gives several warning shots before it falls. Investors should look for these clues as to what the market is telling us along with watching the VIX on daily basis. At this time VIX is low, market is rising upward and VIX can go lower towards mid-12. Therefore, we should consider this as a blessing and enjoy the market’s uptrend while it lasts.
Chart of $VIX is shown below: