Let's start by taking a look at what drives the S&P 500 Volatility Index (VIX).
Okay great, I am so glad you understand. For the answer to the riddle above click here.
The recent drop in the VIX has created waves of articles and news reels analyzing who, what, when, where, why, and how this could, would, and should have happened. Most of these are fillers for slow news days, something plentiful lately. The common theme I am hearing is, the VIX is low and this will cause _______ or lead to _______.
Two questions we need to answer here:
1. What really drives the VIX?
2. What does the VIX predict?
The only correct long-term answer to what drives the VIX is economics. The correct short-term answer is everything (geopolitical crises, politics, disasters, market corrections, market expansions, ECB, Janet Yellen, etc.). Today we are only going to focus on the longer-term.
Below is a chart that shows how the VIX and the S&P 500 Index have performed since 1990.
The first thing I notice, when looking at spikes, is a correlation. When the S&P 500 Index spiked higher, the VIX spiked lower. When the S&P 500 Index spiked lower, the VIX spiked higher.
None of this VIX data, in my opinion, predicted future moves in the market or caused any future moves. For an example, check out the chart below.
On August 28th, 2008, the VIX stood at 19.43. Two months later the VIX stood at almost 80. The VIX offered little insight or prediction of the impending market crash. Instead, the VIX reacted to the S&P 500 Index movements simultaneously.
When I say the VIX offered "little insight" I mean this: The VIX is like the blood pressure of the market. A reading, in my opinion, around 20 means the market is nervous. Under 15 and the market is healthy. Over 30 and the market is having a heart attack.
However, a reading is just that. A frozen snapshot in time. It gives no indication of how the market will react. The trend is more important. Is the VIX trending up or down is the question you should ask yourself.
In 2008 the VIX started showing signs of worsening blood pressure (trending up). A wise investor would have taken note of this and possibly remained on the sidelines until a better health reading was reached.
What about the low VIX today? Below is a chart of the S&P 500 Index and VIX since January 1st, 2013.
The VIX has responded to the healthy market with an ultra-low reading (historically). Economic conditions have improved drastically over the past several years. The market's blood pressure reading is reflecting that. Does this spell complacency? It very well could. As long as economic data continues to remain positive, the VIX will remain low over the long term.
Final Note: For the final note I wanted to discuss the economic portion of the VIX in more detail. Check out the chart below, courtesy of Investopedia.com.
We are currently in a period of expansion. Until the market peaks, expect the VIX to remain low. Understand that this low reading is not a predictor of future market performance. Know that economics truly drives the VIX.
I rely heavily on the investing.com economic calendar to keep track of weekly data. I observe and analyze results each week to stay on top of developments. I also monitor politics, world affairs, central bank policy, and crises to see if short-term VIX trading opportunities may arise.
Take advantage of changes in the VIX!
The VIX is not directly investable so the Chicago Board Options Exchange (NASDAQ:CBOE) offers VIX Futures. Several EFTs and ETNs exist to track these futures.
My two favorites are:
- ProShares Ultra VIX Short-Term Futures ETF (NYSEARCA:UVXY) 2x Leverage
- ProShares Short VIX Short-Term Futures ETF (NYSEARCA:SVXY) 1x Leverage
Other high volume products include:
- iPath S&P 500 VIX Short-Term Futures ETN (NYSEARCA:VXX)
- VelocityShares Daily Inverse VIX Short-Term ETN (NASDAQ:XIV)
- VelocityShares Daily 2x VIX Short-Term ETN (NASDAQ:TVIX)
- ProShares VIX Short-Term Futures ETF (NYSEARCA:VIXY)
I would like to take the time to discuss why I only talk about high volume VIX futures products. Liquidity is the ability to move into and out of a position quickly. The strategies we have discussed over this series on the VIX require liquidity. I prefer options strategies over directly investing in the ETF or ETN. The higher the volume of options, the lower the bid/ask spread on your transaction will be. For more about the bid/ask spread click here.
When I first started researching and trading options my biggest question was: how do I know if the option is a good price? The answer is, it will have a low bid/ask spread. For example if the bid/ask spread on an option is Bid $1.00/Ask $1.01, then it is a cheap option. You only need the option to move $0.01 to break even on your investment. On the other hand let's say the bid/ask spread looks like this: Bid $1.00/Ask $1.50. This is an expensive option. You need the option to move $0.50 or 50% in order to break even on your investment.
The bid/ask spread also applies to buying and selling stocks or ETFs/ETNs. Higher volume VIX ETFs and ETNs carry lower bid/ask spreads. You can read about an example here.
My number one strategy is to short UVXY or purchase SVXY on a falling VIX. You can read about that strategy here. This strategy requires patience until the VIX has reached an elevated level (not now).
In a prior opinion piece, which you can read here, we discussed how UVXY and SVXY would have reacted in 2008 and 2011. This article contains a strategy you can use now, if you predict an increasing VIX or worsening economic conditions.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.