Without getting deep into complex formulas, essentially, the VIX derives value by looking at the implied volatilities of near-term options on the S&P 500 for the two closest maturities (with at least one week to expiration). This volatility depends on the volume of activity in the options on the S&P 500 as traders increase or unwind their hedges.
One of the most commonly used sentiment indicators, by equity and options traders alike, is the VIX. More fondly referred to as the market’s “fear gauge”, it is somewhat akin to a mood ring for the market. It can not only help traders develop preliminary conclusions about market sentiment overall, but also assist them in determining what kind of strategy to use – whether a hedge or simply a speculative trade .
There is an old adage among traders: “When the VIX is high, it’s time to buy. When the VIX is low, it’s time to go.” The easiest way to view the VIX is to look at it as a number that represents the overall expected volatility of the S&P 500 Index. When the VIX measures high readings (and “high” is very relative), it indicates overall fear in the market during bearish and turbulent times. Lower readings indicate investor complacency – or even apathy, to some degree – when markets are bullish.
There are a couple of things to take note of when studying VIX readings. First, when the VIX trades at extremes relative to the market, it becomes a contrarian indicator of sorts that can give you clues to the market’s next move. For example, take the market we saw between 2004 and 007. Like clockwork, it seemed that whenever the VIX would spike to levels near 20, we saw rallies ensue afterward (see chart below). Likewise, when the VIX touched readings of 10, small sell-offs would occur (even if only for a short while).
As market fundamentals began to shift in early 2007, and the global credit crisis resurfaced, the S&P 500 continued to rise – but interestingly, so did the VIX. When the VIX pierced through 20 in mid-2007, it was an early clue that the market didn’t like what it was seeing. When the markets continued to hold up through most of the year, traders were increasing their hedges going into 2008, and VIX readings continued to rise well above 20 – on up into the 30s. We all know what happened next.
Aside from mere sentiment, a high VIX translates into a higher “fear premium” for other equity options in general – which can be helpful in assessing what type of option strategy to put on. During periods when the VIX is trending higher, you might want to consider switching from buying strategies to selling strategies that take advantage of the higher fear premiums priced into options – short vertical spreads, short naked puts, covered calls , and so on.
Once you’ve determined the overall market volatility per the VIX, it would behoove you to determine the volatility of the individual stocks you’re considering traders on. We use the Schaeffer’s Volatility Index and the Schaeffers to help us decide our next move.