Is the Stock Market's Mood Too Happy?

What is the stock market's current state of mind? Is it one of jubilance or deep sadness? And how can investors use the stock market's mood as a way to profit from Mr. Market's ever changing temperament?

The CBOE S&P 500 Volatility Index (^VIX), which is one of the easiest ways to gauge the stock market's temper, can tell us a lot. Over the past 12 years, the VIX has moved in the opposite direction as the S&P 500 around 80% of the time. In other words, the two gauges are inversely correlated.

A depressed VIX can be interpreted as too much complacency or lack of fear in the stock market. Conversely, an elevated VIX infers a high level of anxiety or fear.

In a July 10 post, Michael Moran at the Chicago Board Options Exchange (CBOE) wrote:

"Since 1990 the average daily close for the VIX Index was 20.3, but in the first half of 2013:

--the VIX average daily close was 14.2, and--the VIX closed above 20 on only two days - June 20th (at 20.49) and June 24th (at 20.11)."

Really, the last two years have been a period of muted stock market gyrations. Since late 2011, the VIX hasn't traded above 30. (See chart below)

And although the VIX is now back to trading at just under 14, there have been tremendous spikes along the way, each packed with money making opportunities for anyone paying attention. Let's examine just one recent example.

From May 24 to June 20 the VIX surged just over 46%. And per our June 2013 ETF Profit Strategy Newsletter (published on May 23, 2013) we were able to precisely identify this high profit setup. We wrote:

"Our favorite way to trade the VIX is not with VIX exchange-traded products (ETPs), but rather using VIX call and put options. We like the flexibility of being able to customize our VIX trades with specific strike prices and specific time horizons. We now recommend rolling into the VIX JUL 13 calls (VIX130717C00013000) at $370 per contract."

We rode the 46% spike in the VIX and stock market volatility and per our June 24 alert we sold half our VIX JUL 13 call options position for an 84% gain at around $680 per contract. On July 3, we alerted readers to sell the remaining half of the VIX position at $450 contract.

As the S&P 500 (NYSEARCA:SPY) pushes within striking distance of all-time highs (1,687), confidence in the stock market's rally is thwarting all fear. And for VIX bulls, the translation should be as clear as the daylight.

The ETF Profit Strategy Newsletter uses a combination of technical analysis, market sentiment, and common sense to be on the right side of the market. Our mega-investment theme report along with our weekly ETF picks and technical forecast strive to uncover market extremes along with the best way to profit.

P.S. Beware of VIX ETPs like the ProShares VIX Short-Term Futures ETF (NYSEARCA:VIXY) and the iPath S&P VIX ST Futures ETN (NYSEARCA:VXX). At times, they will be down when the VIX is up and vice versa.

P.P.S. Besides suffering from too much tracking error, we do not believe VIX ETPs are reliable volatility measures. And for anyone trying to make a long-term bet on volatility, better think again. Since its inception in 2009, VXX is down almost 99%!