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The VIX Index
The Smart Profits Report: Issue #132
Thursday, August 05, 2004
The VIX Index: Instant Access to the World’s ‘Best Contrarian Indicator’
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
You may have heard of the VIX Index. The term is bandied around often by financial analysts, pundits and those trying to impress at cocktail parties.
The VIX is formally known as the CBOE Volatility Index. (The symbol for it is ^VIX.) The VIX is an index that was created to track how “jumpy” the market is:
- A high VIX number implies extreme fearfulness on the part of investors, and means prices are bounding up and down a lot. Every time a stock falls a bit, a flood of investors will sell, causing a bigger drop. Then the minute something does well, a horde will come chasing the latest hot idea and push prices upward.
- A low VIX number implies complacency - generally, it means that people are happy to believe the market always goes up. They will ignore bad news and warnings. They’ll overlook high valuations and hold overoptimistic expectations.
The index is calculated based on prices for S&P 500 index options. Because option prices incorporate a premium for volatility, the VIX gives an instant reading on how volatile investors expect the market to be over the next 30 days. But its most common and important use is to measure investor sentiment.
In fact, you can use the VIX, just like the savviest pros do, to increase your chances of making good decisions with your stock and option trades. While it won’t be the only indicator a smart investor uses, the VIX does provide a nifty addition to the toolbox. Let me explain…
Worry When Others Don’t, Using The VIX
Essentially, the VIX just tells us whether investors are fearful (and overly pessimistic) or complacent (and too optimistic).
An extremely low volatility reading tends to occur when the market is about to peak, and extremely high readings hit right before it is about to take off.
For instance, in July 2002, after the market had been bearish for more than two years, the VIX hit a high of 48.46, indicating extreme fear and pessimism. At that point, the market was approaching its bottom. It would have been the time to buy.
Last week, the VIX closed at 15.32 - indicating relatively bullish sentiment and complacency. Is it time to sell?
A Quick Guide To The VIX Index
Here’s a guide - just a guide, mind you:
- When the VIX is high, in the 40s, it’s time to go long - fear is becoming overdone.
- If the VIX is low, under 20, it’s time to hedge or pare down your stock holdings.
The implications are pretty clear: It may be time to scale back your stock and option exposure…
Of course there are other factors involved in how you handle your portfolio - but the VIX has always been the professional’s best contrarian indicator.
Finally, do take VIX readings as a warning… but don’t take them as oracular truth.
Every low reading will not successfully predict an immediate rise in the market; nor will every high reading mean the market is about to fall. Instead, you should use the VIX as a weathervane and be prepared for market changes when it is at extremes.
Good Trading,
Karim Rahemtulla
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Today’s Smart Profits Cribsheet
- Until recently, the VIX was calculated on the volatility of S&P 100 options. If that’s what you want, it has a new symbol, ^VXO. (It is also called the “Old VIX.”) There is also a volatility index called the ^VXN, which may give you a better reading of the tech sector as it is calculated on a basket of Nasdaq options. (the ^ symbol can be found over the number 6.)
- For more information on such option terms as “The Vix” or “volatility” look no further than our free Smart Profits Glossary.
Related Articles:
- Fast and Furious Volatility is Back in a Big Way: How To Profit Using Leg Spreads & The VIX
- Market Volatility: How to Pay $27 for a $50 Stock
- Understanding Options Risk: How to Beat the “Volatility Premium” on Options
