Published October 08, 2012
"Be fearful when others are greedy and to be greedy only when others are fearful" is a well-known adage attributed to the famed investor, Warren Buffett. What is interesting about his statement is that up until the 1990's there was no generally accepted way to measure real "fear" in the markets. Luckily we now have a few more standard indicators to help with this conundrum.
Today, the VIX indicator is one of the tools used to gauge fear. By measuring the implied volatility of the S&P 500 index options, the VIX tells us the market's expected volatility over the next 30 days. When the VIX (ChicagoOptions:^VIX) rises, expected volatility of the S&P 500 index (SNP:^GSPC) rises, and when the VIX falls, expected volatility of the index also falls. Often a rise in the VIX corresponds to a fall in the S&P 500 as volatility is associated with falling markets more than rising markets.
Before the mid 2000's, the market relied on the VXO (ChicagoOptions:^VXO), which measured volatility of the S&P 100 options (ChicagoOptions:^OEX) to gauge fear. This indicator is still around, but less popular than the VIX.
Tricks with the VIX
Darell Huff wrote in his book in 1954, "If you torture the data long enough, it will confess to anything". I am about to do just that with the Volatility Index.
The VIX typically performs opposite of the S&P 500 and bottoms when the markets are topping and tops when the markets are bottoming. This is shown below with a standard chart of the VIX index compared to the S&P. But, having the VIX and the S&P on different Axes with one bottoming while the other is topping can be confusing and counter-intuitive. Luckily we can look at the VIX differently.
One way to analyze negatively correlated assets such as the S&P (NYSEArca:SPY) and VIX is to inverse one of the assets. Inherent in a stock's price is a fraction of that price divided by a measurement unit (the denominator). In the case of the S&P, it is the S&P price in the numerator divided by a dollar in the denominator giving us its value. With the VIX, it is the VIX's price divided by one measurement unit as well. However, by taking the multiplicative inverse of one of the assets we can make it a fraction and thus flip its scale, similar to a mirror image. To do this we simply divide one by the VIX. The chart below shows that result and the flipped VIX.
This does nothing to the data or substance of the VIX or its relevance; it just changes the scale and puts it opposite of its original direction. This now allows the VIX to move in the same direction of the S&P and better compare them apples to apples with them both now positively correlated. For me it is often easier to analyze and see trends in the chart below than the one shown in the chart above.
What is the Inverse VIX Telling Us?
The S&P is in black and the major price peaks in 2010, 2011, and earlier this year all coincided with tops in the Inverse VIX in red. It is easier to see on the second chart how the inverse VIX tops and bottoms coincide with the S&P's peaks and troughs. Typically those tops also were when the inverse VIX was trading above .06 which I have identified by the solid black horizontal line.
Using these techniques helped us see great short term VIX buying opportunities that we outlined in articles on 8/21 as well as 9/20 and in our updates to subscribers. Looking at the chart above in red, the inverse VIX is in a longer term uptrend that started in mid 2011, but it is also well above .06. This area in the past is where tops in the market formed previously and shows why bulls should be cautious at these lofty levels with complacency relatively high right now.
The VIX (and inverse VIX) is another tool to have in the toolbox. Some ETFs that can be used to take advantage of our VIX trades are the ProShares VIX Short-Term Futures ETF (NYSEArca:VIXY), the ProShares Short VIX Short-Term Futures ETF (NYSEArca:SVXY), and the ProShares Ultra VIX Short-Term Futures ETF (NYSEArca:UVXY).
Tools such as the inverse VIX can help us identify trends and setups that otherwise may be missed with traditional analytical tools. In the ETF Profit Strategy Update we examine the VIX and other asset classes in detail to identify high probability trading setups every Sunday and Wednesday night.
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