Volatility Index Uncovers Market Bottoms

By Investopedia Staff AAA

More and more investors are using options prices offered by the Chicago Board Options Exchange's Volatility Index (VIX), to help determine market direction.

The VIX is one of the investment industry's most widely accepted methods to gauge stock market volatility, and for good reason. Here we'll take a look at why it works and how you can make it work for you in your trading endeavors. (For background reading, see Volatility's Impact On Market Returns.)

VIX 101
The first version of this index was developed by the Chicago Board Options Exchange in 1993 and was calculated by taking the weighted average of implied volatility for the Standard and Poor's 100 Index (OEX) calls and puts. However, in September 2003, this was revised to provide a more accurate depiction of broad market volatility. In essence, VIX is a gauge of investors' confidence or non-confidence in market conditions.

It is important to understand that the VIX does not measure the volatility of a single issue or option instrument, but uses a wide range of strike prices of various calls and puts that are all based on the S&P 500. What is formed is a more accurate measure of the market's expectation of near-term volatility. (For further reading, see Getting A VIX On Market Direction.)

Determining Market Direction
Incorporating a wide range of S&P 500 Index options truly makes this index a cross-section of investor sentiment. The VIX has an inverse relationship to the market. A low VIX - within a range of 20 to 25 - indicates that traders have become somewhat uninterested in the market and generally leads to a period of heightened volatility. The value of VIX increases as the market becomes fearful and decreases when the market feels confident about its future direction. A rising stock market is seen as less risky and a declining stock market more risky. The higher the perceived risk in stocks, the higher the implied volatility and the more expensive the associated options, especially puts, become. Hence, implied volatility is not about the size of the price swings, but rather the implied risk associated with the stock market. When the market declines, the demand for puts usually increases. Increased demand means higher put prices and higher implied volatilities. (For more insight, see Implied Volatility: Buy Low And Sell High.)

For contrarians, comparing VIX action with that of the market can yield good clues on the future direction or duration of a move. The more VIX increases in value, the more panic there is in the market. The more VIX decreases in value, the more complacency there is in the market. As a measure of complacency and panic, VIX is often used as a contrarian indicator. Prolonged and/or extremely low VIX readings indicate a high degree of complacency and are generally regarded as bearish. Some contrarians view readings below 20 as excessively bearish. Conversely, prolonged and/or extremely high VIX readings indicate a high degree or anxiety or even panic among options traders and are regarded at bullish. High VIX readings usually occur after an extended or sharp decline and sentiment is still quite bearish. Some contrarians view readings above 30 as bullish. (For further reading, check out Volatility - The Birth Of A New Asset Class.)

Conflicting signals between VIX and the market can yield sentiment clues for the short term. Contrarians see overly complacent readings as bearish. On the other hand, panic is regarded as bullish. If the market declines sharply and VIX remains unchanged or decreases in value (towards complacency), it could indicate that the decline has farther to go. Contrarians might take the view that there is still not enough bearishness or panic in the market to warrant a bottom. If the market advances sharply and VIX increases in value (towards panic), it could indicate that the advance has farther to go. Contrarians might take the view that there is not enough bullishness or complacency to warrant a top.

Figure 1
Source: MetaStock

Figure 1 shows the VIX indicator from April 2007 to February 2009. As you can see, the VIX spiked in September 2008. This unprecedented rise in the VIX coincided with extreme panic and one of the sharpest drops in the history of the financial markets. The VIX values near the dotted trendline portray a much different picture; they could be used to predict bullish sentiment and a much less volatile period of investing. Given the unfolding of the credit crisis in late 2008 , it is not surprising to see that the VIX was suggesting that panic was dominating the market. (For related reading, see Top 5 Signs Of A Credit Crisis.)

This is an indicator that is rarely out of step when it is viewed from market directions on a broad scale and will more than likely help investors see the bottom forming and the next strong bull market develop.

Conclusion
VIX is one of the most widely accepted ways of gauging stock market volatility. It is often referred to as the "investor fear gauge", and has lived up to this name in its ability to measure times of uncertainty and times of complacency in the market. Even in the most volatile markets, VIX can help investors get a sense of when the market has finally hit bottom - a welcome sign of better things to come.

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