Is the VIX Signaling an Inflection Point in the Markets?

Thursday’s trading left the Dow Jones Industrial Average Index (DJI) with more than an 800 point range.  This day came on the heels of a more than 700 point decline during Wednesday’s trading.  It is safe to say that we are experiencing volatility not seen for decades!  While volatility can be damaging to one’s portfolio, some of the statistical tools can actually give some good guidelines as far as market direction.

The CBOE Volatility Index (commonly referred to as the VIX based on its ticker symbol) is one such tool.  The index actually measures the implied volatility in the market by measuring prices of options that are tied to the S&P 100 index (OEX).  When option prices are low, it means that traders do not expect significant price movement in the OEX.  Conversely, when volatility is high, option traders will pay much more for calls and puts because the statistical chance for wild price swings and consequently higher profits is greater.  The index is often referred to as the “fear index” because as fear rises in the market, traders will essentially pay more for protection buying puts, and are also willing to pay more for calls instead of owning underlying equities which could lose more as the market falls.

Historically, the level of the VIX (the actual number that it hits) has been much less important than the pattern.  For years at a time, the VIX can hover between 15 and 30 but when it reaches a peak and turns back down, that typically signals a short-term low has been reached in the market.  Most recently, however, the VIX has reached levels not seen since the 1987 panic selling that resulted in a full-out crash in the market.  With the VIX trading at these elevated levels today, it is safe in my opinion to consider this a market crash that took place over the course of several weeks instead of several days.  Fear has finally reached a climactic level that should mark a significant low in the market and allow us to begin shaping a market bottom.

When markets hit a bottom, they are often very unpredictable and hard to trade.  Friday’s action with the Dow up more than 300 points intra-day only to close down 127 shows that wild swings are here to stay for some time.  However, this action is helpful as it shakes out the weak holders of stocks leaving only the solid investors who are intent upon holding equities.  Once these strong holders own the majority of investments, there will be little supply left which necessarily equates to higher prices.  So we can expect plenty of back and forth trading and quite possibly a test of the previous lows, but I expect that the majority of the damage has been done and it is time to begin selectively picking out stocks to hold for several months at a time.

I feel highly confident that a year from now we will still be working out the recovery in the economy, but the market will have anticipated such a recovery and be significantly higher than the levels it is at today.  So be wise, stay diversified, but be willing to consider this panic environment as an opportunity to buy some strong investments at significantly lower prices.

Comments appreciated:  Do you view the VIX as a viable tool?  Will the market make new lows before recovering?  Is the dour state of the economy efficiently priced in the market?  Share your views and comment on others…

Comments

[Errol:]

People have been calling the vix as an inflection point for a month now. If you think we have uncovered all of the crap in the economy, you need to get a new job. We haven't even gotten into the crash of commercial real estate yet and the actual severity of a recession dominated by de-leveraging and deflation.

2008 Oct 19 12:56 PM

[bbowen7:]

The longer term problem is that we have been living beyond our means and the credit bureau is foreclosing. That's not so much a problem of the financial markets as of the real world.

2008 Oct 19 02:03 PM

[CLH:]

Very good article Scheidt.

2008 Oct 19 09:25 PM

[DaveW:]

Nice article, appreciate the bearish/bullish balance you struck. The vix is indeed useful, but, like the market itself, it is a difficult bottom-calling tool. Agree with you however, the bottom is forming and is near.....but it is an intermediate or final bottom?

2008 Oct 19 11:58 PM

[topher2:]

The VIX is actually computed from the S&P 500 options, at least since 2003. It is a very viable tool, but must be looked at for exactly what it is. It includes a wide range in its calculation and is a volatility surface, not simply implied volatility. It also needs to be looked at in terms of historical volatility, which is currently at 95 percent, far higher than the VIX.

2008 Oct 20 12:33 PM

[topher2:]

The VIX is actually calculated from the S&P 500 and includes a wide variety of options. It is highly viable, but must be seen for what it is, a volatility surface, and should be viewed in terms of historical volatility, currently at 95 percent.

2008 Oct 20 12:35 PM

[Zachary Sch...:]

Thanks for the comments guys!

Of course the VIX is only a tool - and an imperfect one at that. But it does signal the amount of fear in the market. Such fear is cyclical and will at some point abate.

Regarding the economic difficulties, I am not arguing that "everything is ok." I am not even saying that this is THE bottom. Only that we are in the process of forming a low that should hold for a period of time.

The market should trade well ahead of the economy which means it will start heading higher well before the economic picture turns. However, we can't be certain when this turn will take place.

I, for one, however, am riding with a fairly high amount of long exposure.

2008 Oct 30 06:57 PM