Use the VIX as a Directional Market Indicator

Includes: SPY, VXX, VXZ
by: Peter F. Way, CFA

The VIX index, a measure of anticipated market VOLATILITY or UNCERTAINTY, gets labeled the "fear index" and appears to jump around almost erratically.

Unless you are skilled in options trading, the VIX may only be a curiosity.

Now there are both VIX futures (CBOE/FCE) and a VIX-related ETN (NYSEARCA:VXX) available to play with. Don Fishback has just written a very good Graham&Dodd analysis of the VXX at Seeking Alpha that should discourage anyone from exploring that ETN with real money.

Especially those who learned that, no matter how smart you think you are, investing in things you don't really understand can be detrimental to everyone's economy, including yours.

What is not often recognized by casual observers is that the VIX itself has options that can be traded. Skilled options traders usually employ them to get big leverage advantages when they are convinced a directional play in the market is at hand.

The VIX tends to be a contra indicator, being low when markets have built up strong advances and everything looks too good to go wrong ... go wrong ... go wrong, and then jumps up high when it does and no one seems to know where the bottom will be.

For a long time the VIX seemed to range over a span of 10 at the low end to 40 at its tops, with 20 or so sort of a central tendency. But then came last year's September Crisis and the VIX rocketed to 80.

As things struggled to get back to normal the VIX hovered between 40 and 60 until the notion became accepted that perhaps a bottom had been reached in March. Since then the VIX has gradually been working its way down to between 20 and 40.

But as that has been going on, and particularly of late, the market has been undergoing short spasms of decline and recovery. One currently is in progress. The last 4 days has seen the VIX jump from 20 to 28, a 40% advance. Some VIX options are up +100% or more. The S&P500, or SPX, has declined by -4 1/2%.

Wouldn't it be great to know when to get aboard that kind of a ride?

This is speculation, not investing. But because there seems always to be an appetite for such gambles, I'll let you in on what we find in looking at how the options pro traders are behaving.

The analysis is the same as what we use to identify the expectations of the big volume market makers in stocks. Here the players are a different bunch, with very different tempraments and behavior limits. But they are driven to operate from the same set of logical rules while seeking low-risk, high-probability profits.

The accompanying chart shows what the options pros must believe could (not will) happen to the VIX's price in the near future -- two weeks to two months. The green days are where the expectations range is virtually all higher than the heavy dots that mark the end-of-day values for the VIX.

VIX forecast history

On a short-term basis the VIX typically moves contrary to the SPX. Under the right extreme circumstances expectations for changes in the VIX can point to changes in the S&P500. Here is a picture of how nearby SPX moves relate to where VIX expectations are in terms of its present price. (The VIX metric is like a stochastic, but uses our derived forecasts rather than backward-looking price history.)


Draw your own conclusions.

Disclosure: No current positions in VIX, SPX or VXX