Measuring Market Volatility: Another Look at VIX

A recent Bloomberg article was headlined "VIX Tumbles Most in 19 Years as Profits Calm Equities." Almost none of it was correct, but the most obvious error was the assertion that the 31.9% six-day decline ending last Wednesday by the "volatility index" was the biggest ever. In fact, the VIX dropped 48% in a six-day period following the 1987 crash, and it fell 40.9% in the six days ending November 4, 2008, during the financial crisis.

More important than the percentage change is the knowledge that in every instance, a big decline was preceded by a major advance. The November 2008 decline occurred two weeks after a six-day gain of 67.8%. And while we're on the subject, the index increased 532% in the six days immediately following the 1987 crash. (The decline followed that big increase a week or so later.)

All of this is not to minimize the value of the VIX Index. It is an important tool that helps us figure out where we are in the market cycle. So let's see if we can profit from it. There is a good description of it on our Website, in case you want to brush up on the basics. (See: Reading the Financial Tea Leaves.)

First, I want to emphasize that the VIX replaced an older index that is still tracked as the VXO. The two are highly correlated at a level of 98% and have been for the past 20 years, so we will consider them to be interchangeable in this discussion.

The VIX Index is used to estimate how volatile the market is likely to be over the next 30 days. It is based on the prices of Chicago Board Options Exchange options, which are bid higher when traders are nervous and fall when they are not.

Since the market is always more volatile as it falls than when it advances, we generally see the VIX Index climb rapidly and fall at a somewhat slower rate.

We can use the index to estimate the volatility of the market, but we can also do something much simpler. We can actually measure the volatility of the S&P 500 as it moves up and down on a daily basis. This is a fairly simple calculation using the standard deviation of the daily price changes.

One of my readers wrote last Christmas wondering what the relationship might be between S&P 500 volatility and the VIX. His question led me to research the subject and resulted in the design of an oscillator that compares the expected market volatility to the actual volatility of the S&P 500.

Traders use options to protect or "insure" their portfolios. They may buy puts to protect against loss in a declining market. Or they may sell calls against existing positions to add to their income if the stock does not advance. These activities cause option prices to rise or fall and affect the VIX Index.

My oscillator was designed to move higher when traders are not trading enough options to protect their portfolios when the market is very volatile. A high oscillator reading means traders are underprotected, this often leads to a panic and the dumping of stocks when the market moves unexpectedly. So the higher the oscillator reading, the more likely the market is to drop sharply.

The indicator is not a standalone one. Instead, it is a general warning to get out when it is high, just as it is an encouragement to stay in when it is low. The chart below shows the S&P 500 at the top with green markers when the indicator supports buying and red when it supports selling. The VIX Index is in the middle with red markers when it is expected to drop and green when it is expected to rise. The green and red markers are determined by the VIX Oscillator at the bottom of the chart. When the oscillator reading is above the green horizontal line, green markers are placed on the VIX Index and red ones are placed on the S&P 500.

The second chart shows just the S&P 500 with the VIX Oscillator. All the buy and sell signals since January 2004 appear on the plot of the S&P to show when it is safe (green) and unsafe (red) to be in the market. As a general guide, I find it useful, but it is necessary to use some of the other indicators we have discussed in previous posts for fine tuning.

— Fred Goodman, a registered investment advisor and Certified Financial Planner, publishes MarketMonograph, a daily, Web-based subscription service specializing in technical stock market analysis and the application of economic indicators to market timing. You can reach him at fred@marketmonograph.com.