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Chicago Board Options Exchange’s volatility index trading floor.Iain Marlow/The Globe and Mail

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When the CBOE Volatility Index (VIX) rises, small cap stocks fall on both sides of the border. Right now, the VIX isn't providing much of a signal, but a check on its recent performance should be a final step for anyone looking to put money in the small cap sector.

The VIX measures expected equity volatility using options prices. A rising VIX means that option writers – the financial institutions offering call and put options for sale – are expecting bigger moves in equity prices, either higher or lower.

Small cap stocks are historically more volatile than their larger counterparts. When large caps move higher or lower, small caps generally make bigger percentage moves in the same direction.

So, when the VIX rises, investors often sell small caps and buy larger companies in order to protect themselves from a major downward move.

This chart (also at left) shows the results. (I indexed the Russell 2000 and MSCI Canadian Small cap index to 100 to get them both on the same chart.) Small cap stocks have moved consistently in the opposite direction from the VIX.

Investors considering new small cap positions need to believe that the VIX will not move substantially higher. Historically, changes in the level of the VIX have been a better predictor of aggregate small cap performance than valuation levels. In other words, it likely won't matter if your small cap stock is cheap when the VIX rises – it will move lower anyway.

You can decide for yourself, but it looks like the VIX is bottoming here around the 12 level and close to the recent lows of 2006. (Not that I would ever use technical analysis on the VIX. That way lies madness. I'm making more of a subjective judgment based on recent U.S. profit results and bond market volatility.) If the VIX does move higher, small cap indices will move lower.

I think the VIX might move higher, but it doesn't really matter if you believe me or not. The important thing is for small cap investors to follow the VIX whenever making buy or sell decisions.

Scott Barlow is a contributor to ROB Insight, the business commentary service available to Globe Unlimited subscribers. Click here to read more of his Insights, and follow Scott on Twitter at @SBarlow_ROB.

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