Is a Fearless Stock Market Cause for Concern?


Is the VIX flashing a warning sign of trouble ahead for stocks?

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 which focuses on the S&P 500.  The Nasdaq 100 also has its own volatility index, the VXN (CHICAGOOPTIONS:^VXN)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.  

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Tricks with the VIX

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 long-term chart of the VIX index compared to the S&P 500.

But, having the VIX and the S&P inverselycorrelated with one bottoming while the other is topping out can be confusing andcounter-intuitive.  Luckily, we can look at the VIX differently.

The VIX FlipOne way to analyze negatively correlated assets such as the S&P (NYSEARCA:SPY) and VIX is to invert one of them.  To do this we simply make the VIX a fraction by dividing it by one and then plotting it alongside the market.  The chart below provided in our ETF Technical Forecast on 07/31 and updated through todayshows that result and findings, the flipped VIX. 

This chart now allows the VIX to move in the same direction as the S&P to better compare them apples to apples.  (Click here for larger version of both charts)What is the Flipped VIX Telling Us?The S&P 500 is shown in red and the inverted VIX in black.  It is easier to see on the"flipped" chart how the inverse VIX's tops and bottoms typically follow alongside the S&P's very closely.     Using these techniques helped us see some great VIX buying opportunities one of which we outlined for subscribers in our June Profit Strategy Newsletter on 5/24 with the VIX below the 15 level where we wrote, "we now recommend buying VIX JUL 13 calls at $370." 

On 6/24 theVIX shot up to 20, our VIX JUL 13 calls soared to $680 and we advised taking profits of 84% on half the position.  We closed the rest on 7/5 for a combined return of 55%.

Shown by the black dashed trendlines in the "flipped" chart above, the inverse VIX was not making new highs in May, even though the market was. This is called divergence and is a sign the VIX was showing relative strength and a better candidate to hedge your portfolio than outright shorting the market.  It also was a warning sign that the markets indeed were about to pullback, which they did.

A similar formation is occurring once again as the S&P makes new highs but the VIX does not make new lows.  This is shown by the above chart of the inverse VIX.  In black, it is not making new highs above its March levels, although the S&P in red is.  WATCH: Why the VIX is the Go-to Fear Indicator

The VIX is likely warning that the risks to bulls is now elevated, just as it was at the March, April, and May price peaks, just before the VIX rallied significantly. 

Once I see a confirmed trend change on the VIX, it will likely again be time to buy VIX calls for a high probability trade setup. The expectation would be another VIX rally to at least the upper teens from its current price around 13.

VIX linked ETPs include the ProShares VIX Short-TermFutures ETF (NYSEARCA:VIXY), the ProShares Short VIX Short-Term FuturesETF (NYSEARCA:SVXY), and the ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY).  Leveraged and VIX ETPs have many risks associated with them which is why we prefer the purer VIX play of call and put options.Tools like the flipped VIX can help us to identify key inflection points in the market and trends for profiting that otherwise are missed with traditional analytical tools. The ETF Profit Strategy Newsletter and Technical Forecast tracks the VIX along with other major asset classes to locate high probability trading setups every Sunday and Wednesday evening. Follow us on Twitter @ ETFguide