Rule #5: How you can use the (VIX) Volatility Index to Make you a Better Investor/Trader …

The VIX explained:  Few really know what the Volatility Index is, or how it is calculated.  Here’s are two brief explanations … the first is a technical explanation, and the second is a description that investors can easily understand.

First, a brief technical explanation …
The Volatility Index (or VIX) is a weighted measure of the implied volatility for real time $SPX put and call options. The puts and calls are weighted according to time remaining and the degree to which they are in or out of the money.  From this is created a hypothetical at-the-money option with a 30 day expiration time period.  In this way, they are trying to set a value that is equal to the equivalent value of the $SPX’s current price.  (When a stock’s option strike price is “at the money”, it is theoretically the same as the price the stock is trading for at that moment.)   So what does that mean?  It means that the VIX really represents the “implied volatility” for the hypothetical $SPX put/call options on an “at the money” option value.

Second, a Layman’s explanation
Simply put, the VIX is a key measure of market expectations in the near term.  For almost 20 years, the VIX has been considered as a valuable barometer of investor sentiment and volatility.   Another way to look at it, is that it measures perceived risks of investors.   The greater the perceived risks investors have about stocks, the more they buy “protection Put options, when they are long”, which means that the VIX will therefore be moving higher.   When the VIX moves higher, the market moves lower because they are inversely related.

Many talk about the VIX’s implied volatility changes … but, don’t get caught up about the term “implied volatility” if you don’t understand it.    What is important is that the VIX moves up during times of uncertainty or fear, and down during times of greed or confidence.  Since the VIX moves in the opposite direction of the market, you can know what to expect for upcoming market movements by observing what is happening to the VIX.   If you think about it, the VIX is a good example of “the self fulfilling prophecy”.  (The definition from Wikipedia is: “A self-fulfilling prophecy is a prediction that directly or indirectly causes itself to become true, by the very terms of the prophecy itself, due to positive feedback between belief and behavior.”)

How does the VIX work as a self-fulfilling prophecy? 
Imagine that an investor has bought a lot of equities over time and now believes that market risks are rising.  Now he feels that it might be wise for him buy protective Put options in order to protect his equity.    If he believes the market risks are truly rising, he not only buys the Puts. He also stops buying Stocks or ETFs he has.  If he didn’t, it his new actions would be counter-productive.   The mere action of many, or enough large investors who stop their buying is often enough for the market to be unable to sustain its up movement.   Thus the market pulls back and a the self-fulfilling prophecy event occurs.

Since investors have to buy options expiring in the future in order to protect themselves from their perceived beliefs about upcoming changes in the stock market, those actions cause the VIX to move … and the VIX’s movement therefore measures investor expectations of what they believe will happen in the near future.  That’s it … this is all you need to know about the VIX really.

How to Use Technical Analysis on the VIX for knowing when the Market will change direction.

Is there sufficient correlation between the VIX and the Stock Market?   You are not going to like the answer, because the answer is NO if the VIX is used alone.    Most investors are just not cognizant of the fact that when they are investing or trading … they are trying to compete with Goldman Sachs and other large Wall Street firms.   These firms use a multitude of programs and tools to hedge, sell against hedging, and to initiate clean buy’s into the market.

I’m not going to sugar coat using the VIX  … instead, I will show you some of the critical factors that are involved when the VIX is moving up or down.   If anything, it will show you WHY you should not rely on the VIX by itself.

When Wall Street players hedge or play the market, the NYSE Down Volume (Symbol: DVOL) is always a factor with what is going on with the VIX.   So, the first thing we will do is look at the 4 possible VIX to DVOL combinations that can occur, and what they typically mean for the market movements.

Here they are … this chart shows the 4 major possibilities for various VIX and DVOL combinations.   As you can see, there are really 2 important possibilities for investors, and that is when the VIX and the DVOL are going in the same direction … whether up or down together.   (When they are going in opposite directions at the same time, one typically offset’s the other which influences a sideways market move.)


Next, let’s look at an actual chart that shows you these two elements in action.   The chart below is from April to August of 2011.   On the chart, you will see 4 vertical lines, and 6 labels (1 through 6) where the 4 possible conditions are shown.  I won’t belabor the explanation, but instead present a simple matrix chart at the bottom of this chart that explains each labeled occurrence.


Below is the matrix showing the VIX to Dvol combinations that occurred on the chart above and their resulting market action.


“Will a move be a small or large move?”

A significant part of the answer has to do with “how much Institutional Investor Selling is occurring at the same time“.   The Institutional Selling part of the chart (see below) is made up of a 3 day exponential moving average, and 6 day weighted moving average.   Together, these two moving averages depict the short term selling trend being initiated by Institutional Investors.   The “spread-distance” between the red/blue Institutional selling lines depict the amount of selling and the selling trend.

Note how the VIX and the Dvol both peaked in the beginning of August.    Even though the VIX peaked, many were not sure if the VIX was going to continue in an up trend or not.  The answer came just after 48 hours had passed because the Institutional Selling shifted to a down trend (see the yellow vertical line).   Indicator tools like this are important for understanding what is really going on in the market, and why an isolated indicator like the VIX can’t tell the whole story by itself.

Tools like these indicators are important parts to the whole equation, but still they don’t tell the complete story.   It is why we post two to three dozen charts every morning … together, they are necessary in order to “see what the Institutional Investors and Wall Street firms are doing”.

These days, a good part of investing sensibly is to never go against what the Institutional Investors are doing.   The days where a smaller investor can win when going against what the big Institutions are doing are few and far between.