How the volatility indexes can help you understand the market

By Jason Chow
Globe Investor Magazine Online, January 28, 2008

What to make of the stock markets during their bipolar mood swings? Over the past two weeks, massive losses were quickly followed by mini-rallies, then by more subsequent downturns. Markets haven’t given investors this kind of a manic performance in six years.

Perhaps the answers lie in the volatility itself. More specifically, the tricky indexes that track volatility, like the Chicago Board Options Index Volatility Index, better known as the VIX, and the Montreal Implied Volatility Index, or the MVX. For a better diagnosis of the markets’ health, we turn to these gauges.

Since the options market is where traders place pure bets on the future, it’s an ideal way to figure out market sentiment. The VIX index is a measure of “implied volatility” of the Standard & Poor’s 500 index, which is a fancy mathematical concept used to determine how far the options traders are betting the S&P 500 will fluctuate. It’s complicated math, but the VIX formula takes the values of call and put options of the S&P 500 and the resultant figure is how much the options markets have priced in the S&P index to move over the month. So if the VIX is reading 20, that means that options markets think that, in the next month, the market will fluctuate at the annualized rate of 20 per cent.

Lost already? Here’s a simpler way of looking at it: Imagine that the VIX is like a thermometer for market fear. Typically, the VIX remains low and steady – in the low teens – during bull runs but when the market is really scared, the reading reaches fever-high levels. Most market pundits look to 30 as the fever threshold for the VIX index. Earlier this week, the VIX index went as high as 37.57, levels that haven’t been reached since 2002 and among the highest in its 15-year history.

The MVX works the same way, measuring the volatility of the S&P/TSX 60 and it too reached historic highs this past week, spiking to 36.23 and very close to its record high of 36.32 from Dec. 21, 2007. (The index has been in existence since December 2002.)

Traders look at these indicators to gauge market sentiment and the VIX is telling them right now that investors are scared out of their pants. They also look at the VIX as a market timing indicator: When the VIX reaches a high, it’s time to get back into the market and go bottom-fishing.

“It’s a contrarian’s market sentiment signal,” says Bill Luby, a trader in San Francisco and writer of the VIX-centric blog Vix and More (vixandmore.blogspot.com). “It says people are too panicky and anxious. And there aren’t many people left to panic. When the VIX reaches a high, it’s a market sentiment tipping point.”

Does right now look like a time to buy? Perhaps, says Mr. Luby. But he’s remaining cautious and, of course, is measuring VIX against other market-timing indicators.

“Lots of people are saying, ‘It’s finally about the August levels. It’s now looking like a good buying opportunity.’ Of course, those are only the brave souls. This could be a bear trap but I’m measuring time at the moment.”

Marius Alexe, chief market analyst at Phincorp Capital Markets in Montreal, points out that while the market made new lows this past week, VIX did not make new highs that exceeded its last-August highs, back when the markets went south after the subprime mortgage story first hit. The fact that the VIX didn’t make new highs is significant, he says.

“The VIX is sticking at the highs [from August] and that means you might get some temporary support. Selling is abating for now and you might get a bounce for one or two weeks. But i would not use this setup to go long for months. I don’t think we’ve got the evidence for a sizable rally yet.”

Mr. Alexe points out that the VIX is just one of many indicators one should look at. And he adds that using the VIX to gauge market sentiment is similar checking a person’s temperature for a fever. Illness may last a few days or several weeks– one never knows by only measuring body temperature, though it’s likely to revert to normal after a while.

“Sentiment is important but it has no timing, but markets will always pull back from extreme sentiment,” he says.