The Ambiguous VIX: A Fear Gauge Or A Contrarian Indicator

| About: iPath S&P (VXX)

VIX (NYSEARCA:VXX) is often referred to as the "investor fear gauge." Investopedia states that:

"VIX values greater than 30 are generally associated with a large amount of volatility as a result of investor fear or uncertainty, while values below 20 generally correspond to less stressful, even complacent, times in the markets."

But not all investors are alike and do not experience the same emotions due to market swings. We know from experience that when panic hits the market and retail selling accelerates, long-term professional investors are often on the buy side. Thus, it appears that generalizations regarding VIX as far as its relation to investor emotions may not be fully justified. After all, for every buyer there must be a seller.

For example, when the S&P 500 index (NYSEARCA:SPY) made an intraday low of 666.79 on March 16, 2009, apparently some investors were buying the shares sold by others ruled by fear. I believe that the buyers were acting based on a well-thought plan free of any emotions. In other words, I believe that prudent and savvy market timers are nearly emotionless. To an emotionless investor, an unsophisticated "investor fear gauge" may serve as a contrarian indicator. In my opinion therefore, the designation of VIX as an "investor fear gauge" fails empirical confirmation. It is not a general rule that applies to all investors, and it only describes the emotional state of a fraction of them whose actions are best described by it.

Fundamentally, VIX may be a much simpler indicator

Investopedia also states:

"Definition of VIX - CBOE Volatility Index: The ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts."

The above statement alludes to a complicated construction for VIX, but a chart of the 60-day rolling correlation with the S&P 500 index shows that the daily changes in VIX are highly anti-correlated with the index daily price changes, as shown below:

The above chart shows that during the last 7 years, the S&P 500 index 60-day correlation with VIX has stayed below -0.60 and for extended periods of time has stayed at levels near or below -0.90. Currently, the correlation is near -0.70. This means that there is a strong inverse relationship between daily changes in the index price and corresponding daily changes in VIX. This is also clear from experience: when prices rise VIX usually falls and when prices fall VIX usually rises.

Based on the above facts, quantitative and empirical, a much simpler hypothesis arises that VIX, for the most part, simply tracks the inverse of price. The following chart shows a plot of the inverse of daily closing prices of the S&P 500 index and its correlation with VIX. As expected, the correlation is now positive and has remained moderately high to very high during the last seven years:

The observations just made provide empirical support to the hypothesis that

VIX = f(1/P)

i.e. that VIX is, for the most part, some function of the inverse of price P.

The simple relationship above emerges from the implied volatility of options because during up trending markets, the following occur:

  • Investor flocking - some investors buy stocks because some other investors buy stocks
  • Momentum trading - investors and technical traders buy on strength
  • Trend-following - technical traders and funds follow the price trend

Thus, higher prices send prices higher due to the three main mechanisms listed above, as long as fundamental conditions remain the same. As a result, VIX usually falls with rising prices. When fundamental condition change and some investors start selling, then VIX rises because of this simple relationship, i.e. due the fact that it is a function of the inverse of price.

VIX as a contrarian indicator

Extreme levels of VIX could mean that a reversal in market trend is imminent. In rising markets for example, very low levels of VIX, like those we are witnessing recently, could mean that the flocking behavior of investors, and recently of robots, has reached levels where any small negative perturbation in fundamentals from their current state could cause a rapid massive exit and a correction. It is usually those who fear of losing that sell first. Their actions in turn cause technical sell signals and tend-followers to exit the market and VIX reaches higher levels. The conclusion from this angle of analysis is that the dynamics of VIX and the emotional state of investors cannot be effectively mapped. Some investors feel fear at high VIX levels because they are afraid of a further correction and some others during low VIX levels because they think the market is overextended. What is important in my opinion is to realize that VIX is highly correlated with the inverse of price and that extreme high VIX levels often present opportunities for accumulating shares at lower prices, while very low levels often signal the start of distribution to weak hands.

A side conclusion from this analysis is that unsophisticated stock market investment risk is inversely proportional to price. According to this simplistic notion of risk that I attribute to unsophisticated investors, as prices fall, the probability of falling even more increases and as prices increase the probability of going even higher increases. In my opinion, I think that behind the fancy descriptions of how VIX is calculated, the underlying process that determines its level is the unsophisticated notion that a lot of investors have about risk, which was just described, that is linked to price levels in conjunction with their portfolio value: low prices imply higher risk for their portfolio and higher prices imply lower risk. Of course, this is in contrast to the perception some sophisticated investors have when they see opportunity to buy when the crowd is panicking and sell when the crowd feels euphoric. To those sophisticated investors, VIX may serve as a contrarian indicator. But what is important regardless of investors' emotional state and sophistication level is that VIX just follows the inverse of price for all practical purposes, as the charts and analysis showed.

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. I have no business relationship with any company whose stock is mentioned in this article.