Who's Afraid Of The Big Bad VIX?

ABOUT THE VIX
The Volatility Index (VIX) was introduced by the Chicago Board Options Exchange (CBOE) in 1993 and rapidly became a benchmark for US stock market volatility. It was originally based on the S&P 100 index (OEX), but in 2003 it was changed and now is based on options on the S&P 500 index (SPX). In 2014 the SPX Weeklys were included in the VIX.

The VIX is a measure of the implied volatility of S&P 500 index options. Often referred to as the fear index or the fear gauge, it represents one measure of the market's expectation of stock market volatility over the next 30-day period. The computation of the index is complicated, but if you are interested in finding out about it, there are several sources with this information. Needless to say, most of us are happy that most charting programs have the indexes built in. Notice I said "indexes," as there are many of them. Besides the VIX, the CBOE calculates volatility on other indexes such as the NASDAQ, the Dow Jones industrial Average, and the Russell 2000. You'll also find volatility indexes on commodities, foreign currencies, individual stocks, and exchange traded funds (ETFs).

The need for such an index came about as it was recognized that there were many forms of hedges used by professional and individual traders, but there was no way to measure volatility. The VIX is quoted as a percentage point corresponding to the expected movement in upcoming 30-day periods. The VIX has an inverse relationship with the market (if measuring the market) or to a stock (if measuring a stock). High VIX readings indicate there is a high probability that the market will see a sharp movement in the opposite direction. It's an indication that the fear is building up. Low VIX readings suggest a low-risk environment and a period of complacency. In the first quarter of 2015, the high was 23 and the low was 14. Compare that to the high on October 31, 2008 of 81.65 just before the major indexes bottomed.

How can you use the VIX to get a better understanding of the market and how can you use it in your trading? There are different ways to use the VIX. You can use it to hedge positions, as a speculation tool, and to diversify your portfolio. Since the VIX is negatively correlated with the S&P 500 index, a high VIX value would suggest that the trading instrument you're considering is unlikely to go higher. In fact, it is more likely to take a steep move in the opposite direction.

FIGURE 1: VIX COMPARED TO MAJOR INDEXES. The VIX peaked at every trough of the indexes.

Figure 2 shows the VIX for Apple (VXAPL) vs. the stock of Apple Inc. (AAPL). You can see that AAPL was in a continuous downtrend on March 13, 2015 and the VXAPL fell from a high of 30 to around 27. In such a scenario I wouldn't jump into buying something like the March 20 calls. I would wait a day or two to see how this plays out.

FIGURE 2: VIX FOR VXAPL VS. APPLE STOCK. The stock price is in a downtrend and the stock's VIX has come off a high.

In Figure 3 you see the VIX for Google (VXGOG) vs. Google (GOOG). Google has not been showing any upward movement and the VXGOG shows this inverse relationship.

FIGURE 3: VIX FOR GOOGLE VS. STOCK. There's not much upward movement in the price of the stock and the VIX is showing the opposite movement. Does this mean that GOOG has reached a low?

The VIX was originally plotted for the S&P 500, so let's check on the viability of buying options related to the S&P 500 index. Given that the SPDR S&P 500 ETF (SPY) is a natural choice, I'll use it to check on the viability of purchasing March 20 calls. In the chart in Figure 4 you see the VIX in contrast to the SPY. Note that the SPY has not had much movement, whereas the VIX has shown some volatility. Which way will the SPY go? It's hard to say at this point, so I would wait till the inverse movement between the two is obvious before purchasing the March 20 calls.

FIGURE 4: VIX VS. SPY. Is this a good time to purchase the SPY March 20 calls?

FIGURE 5: VIX VS. SKYWORKS SOLUTIONS (SWKS). The VIX is out of sync with the price of the stock, which has been in a strong bull rally.

FIGURE 6: VIX VS. NXP SEMICONDUCTORS (NXPI). The stock has been in a strong uptrend and the VIX is low.

FIGURE 7: VIX VS. AMBARELLA INC. (AMBA). Here is another example of a stock that is in a bull trend and has a low VIX reading.