The VIX is entering a zone that has been historically good for the market.
The Chicago Board Options Exchange Market Volatility Index, VIX, is the implied volatility of S&P 500 index options. It is popularly referred to as the fear index and represents the expected 30-day measure of the market's volatility. High volatility means higher market risk and low reading means lower risk.
There are many strategies that use overextended VIX reading as buy signal and an extended period of low VIX reading as a sign of market top. An example is CVR3, a short-term strategy to time S&P 500 trades developed by Larry Connors and Dave Landry.
SPY - the SPDR S&P 500 Trust - is a good proxy for timing the S&P 500. For the purpose of this thesis, SPY and S&P 500 can be used interchangeably.
In the past few months, using a strategy like CVR3 would have worked quite well. In August 2011, VIX reached above 40 and S&P 500 made a low that started a rally lasting till March 2012 - a gain of more than 30%. Then VIX reached the lows near 15, which signaled the top for the market - at least until now.
In 2010 too, a reading above 40 coincided with falling market, though the turnaround happened when VIX was dropping from a high of 48. The subsequent rally was worth approximately 35%. The market decline in 2011 started when VIX again reached the vicinity of 15. The drop reduced SPY by nearly 20%.
The case was similar at the height of 2008 financial crisis and at the top of the first leg of the rally from 2009 lows to 2010 high.
VIX is again flirting with a reading of 15. So should you take this as a signal that the market is topping out and that it is ready to topple over and that you need to get out of the market?
The History of VIX Says - Not So Fast!
History says that the VIX has a tendency to stay above 15 for a long period of time only to drop below it and then stay there for a long stretch too. At least, when the VIX is below 15, S&P 500 has somewhat smoother gains, whereas with a VIX reading above 15, the advances and declines are shaper.
Historical Aberration! - Perhaps Not!
Since July 2007 VIX has dipped below 15 only three times. First dip was in April 2011 lasting couple of weeks. During the time VIX was below 15, S&P 500 reached the high for 2012. Second time was in March 2012 for three weeks and S&P 500 saw the high of 2012. The third occurrence is this week in early August and S&P 500 is again challenging the 2012 high.
If VIX stays within a 15-to-10 zone for an extended period then, going by history, it behooves well for the bulls.
Since 1990, VIX has twice stayed within this zone for a protracted period. Both periods saw big increase for S&P 500. See the chart of monthly VIX with S&P 500 (the chart of VIX with SPY is at the end of this thesis paper).
VIX dipped below 15 for the first time in May 1992 (VIX is available since 1990). In the several months before that, VIX had made few trips below this level but did not stay for long. From May 2992 to November 1996, a stretch lasting 235 weeks, VIX spent lot of time fluctuating between 15 and 10 with few short spikes - lasting 2-8 weeks - above the upper limit.
During this time, S&P 500 rose from 412 in May 1992 to around 742 in November 1996 - a gain of approximately 80%. The extended trading within this zone was preceded by a low of 295 for S&P 500 in October 1990, which was almost 50% retracement of the rally from October 1987 low of 216 to August 1990 high of 370.
In November 1996, VIX left the trading zone of 15-to-10 for a very long time and did not visit below 15 till December 2003 - a period stretching 400 plus weeks. During this time, VIX traveled upwards of 30 many times and three times it reached above 40. Also, S&P 500 reached an all-time high in March 2000 and collapsed immediately after that high.
The second prolonged stay of VIX in the 15-to-10 zone started in August 2004 and lasted till July 2007 - a total of 152 weeks. This long stay was preceded by a 28% retracement of the rally from the low of 806 made in February 2003 to the high of 1163 made in March 2004. When VIX left 15-to-10 zone again for a long time, S&P 500 was trading near all-time high. The overall gain - from 1065 to 1555 - was approximately 46%.
Now, VIX is again flirting with 15-to-10 zone after staying above it for over 265 weeks. Also, recently, S&P 500 retraced almost 50% of the previous rally - August 2011 low of 1122 to March 2012 high of 1422. Like previous two times in 1992 and 2004, 2012 is also a presidential election year - the incumbent lost in 1992 but won in 2004.
If the stars align properly then VIX may stay within this zone for a lengthy period and the S&P 500 may extend its gains. Just food for thought if you are thinking that a low VIX reading is signal to either abandon the market or go short.
The chart of VIX & SPY is similar.
There are many other ways to use/trade VIX. This is from another SeekingAlpha article:
VIX options are a great tool to hedge your portfolio from systemic risk, but trading actively on the VIX itself is very risky. Trading the VIX is so risky that an ETF tracking 2X (NASDAQ:TVIX) the movement of the VIX fell over 60% last week. Additionally every bet made on the VIX is zero sum, meaning that no actual wealth is created - it is just re-distributed.
For investors who are not familiar with derivatives, there are always other ways to trade the VIX index including ETFs such as iPath S&P 500 VIX Short-Term Futures (NYSEARCA:VXX), VelocityShares Daily 2x VIX Short Term , and iPath S&P 500 VIX Mid-Term Futures (NYSEARCA:VXZ).
Disclosure: I am long SPY.