Before You Get Freaked Out By The Rising VIX

So the VIX, known to some incorrectly as the “fear gauge” has been rising. And so has the S&P 500. And some are saying this is bad news. Zero Hedge throws us a short term bloomberg chart with a pithy “Stop Trading” headline. Bloomberg tells us that the rising VIX is a sign that the recently strong S&P 500 rally is about to end.

    The Chicago Board Options Exchange Volatility Index, as the VIX is known, gained 3.5 per cent to 25.89. The S&P 500 added 3 per cent, giving it a 6.1 per cent gain since July 10. They have both advanced 25 times since the subprime crisis began in August 2007, according to data compiled by Bloomberg. The next day, the S&P 500 fell 18 times for an average loss of 1.6 per cent.

    “That is remarkable,” Randy Frederick, head of trading and derivatives at Charles Schwab in Austin, Texas, said of the tandem move by the S&P 500 and VIX today. “The VIX is expecting something here, either a pull back this afternoon or tomorrow.”

    Both indexes rose on July 6. The next day, the S&P 500 retreated 2 per cent. The volatility benchmark, known as Wall Street’s “fear gauge” because it almost always increases as stocks fall, reflects expectations for price swings for the next 30 days. Higher levels signal more risk in equities.

And today the market is down a bit/flat right now. Was it the VIX? Is this necessarily worth so much concern? Is the VIX action a robust signal or simply another piece of market static?

Sure the VIX is rising, but we need to put the current VIX level into perspective and be clear about a few things before jumping to any conclusions. Might the market fall tomorrow? Sure it could. But it also couldn’t. And the VIX is unlikely to be a robust method for telling us either way in the current environment given where it is now and where it has been recently. Why.

First of all, while some refer to the VIX as a fear gauge, and seem to believe that a higher VIX means bad news for equities, this is not necessarily true. A higher VIX means options traders expect more volatility for stocks, up or down. And I emphasise the word “expect” in the previous sentence. Options traders can be wrong.

Second of all, while the VIX has risen, we need to remember where it has been recently. Take a look at the chart below.

Look at where the VIX was late 2008. Sure today it is high compared to earlier years, but it is low compared to where volatility has been more recently. One can’t expect market expectations for volatility to suddenly return to 2005/2006 levels (which aren’t shown above, but were lower than 2007) after experiencing the tumultuous market moves of the last 10 months. Thus put into recent context, while the VIX is high relative to previous long term levels, it is actually arguably low or average if we take into consideration the end 2008 market gyrations.

And going back to what the VIX is… let’s also remember that it can be wrong just like stock market consensus can be wrong. Am I saying the market is set to rise? No. This isn’t about calling the market’s next short term move, but rather not getting caught up in getting concerned over the wrong issues.

So put the VIX in context, it’s not a death signal. It could be wrong on expected volatility and actually fall, or it could even be high due to expectations for an upward spike in stock prices. And it’s not at very high levels given the current market environment of heightened volatility. A lot of large stocks have been creamed from their levels over the past few years, they can thus retrace a lot of lost ground on simply un-ugly results.

Final point to keep in mind. The “safe” analyst advice, currently, is to be sceptical of a rally. This at the very least should push investors to hunt around for strong stocks perhaps still facing too much negativity, especially lesser known non-financials with strong balance sheets and well established businesses. And perhaps then turn them into covered call trades (but still leaving upside on the stock) if you want to hedge yourself a bit, a higher VIX means you’ll capture richer premiums.

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