Reading the Financial Tea Leaves

Elaine Garzarelli morphed from a relatively unknown financial analyst into a market guru when she correctly predicted the October 1987 stock crash. Just a week before Black Monday, Garzarelli warned that the market was overvalued.

She became a legend on Wall Street, where bold predictions can turn analysts into celebrities. Do Wall Street prognosticators have secret insight into the market's direction and fury? Do they rely on skill, luck, or a little of both?

The market is skittish and hard to predict. But there are tools industry experts use to gauge its probable direction, particularly the VIX. In 1993, Duke University professor Robert E. Whaley, an expert in derivative securities, introduced the VIX. Based on his concepts, the Chicago Board Options Exchange (CBOE) introduced the CBOE Volatility Index.

The VIX originally measured the near-term volatility of S&P 100 stock index option prices. In 2003, the CBOE changed the formula to target S&P 500 stock index option prices, the core index for US equities.

As it stands today, the formula estimates expected volatility by averaging the weighted prices of S&P 500 puts and calls over a wide range of strike prices. The sole purpose is to "replicate" volatility. Since its genesis, the VIX has evolved from an abstract concept into a practical forecasting tool. It is widely considered the premier barometer of US investor sentiment and market volatility.

The VIX has become the media’s darling for picking where the market is heading. It’s a staple of publications such as The Wall Street Journal and Barron’s, as well as broadcast outlets including CNBC and Bloomberg TV.

The VIX is quoted in percentage points. It determines an annualized rate of volatility, based on the expected movement of the S&P 500 index during the next 30 days. For example, on February 22, the stock market had a precipitous decline of 2.05%. Meanwhile, the VIX shot up to 20.80, a 26.6% increase.

Based on the VIX, the market was experiencing greater short-term volatility: It was facing a potential "annualized" change of 20.8%. Theoretically, that meant the market could move up or down 20.8% during the next 12 months.

But keep in mind the VIX measures short-term volatility. To understand this, investors have to determine how much movement is likely only in the next 30 days. Based on the annualized projection, the market could move up or down about 6% in about a month. (To determine short-term volatility, divide VIX by the square root of 12 or 3.46410162.)

The VIX measures implied volatility. Implied volatility generally increases in the VIX when the market is bearish and decreases when the market is bullish. In theory, bear markets are more risky than bull markets. Historically, the VIX falls when the market rises and rises when the market falls. In a bull market, the VIX typically trends down, and in a bear market, the VIX typically trends up.

Before the introduction of the VIX, investors used intuition to determine market volatility. Now, there is empirical data to help predict where the market is heading. Could a quick look at the VIX turn you into the next Elaine Garzarelli? Maybe. But even if it doesn’t, it just might make for some really good cocktail conversations.