Index Intelligence: Listen Up. VIX Might Be Saying Something

The CBOE Volatility Index is a forward-looking indicator. It reflects the expected volatility currently priced into S&P 500 Index () options. When investors are concerned about a possible stock market drop and/or an increase in volatility, they often purchase puts on the S&P 500 Index. The increase in demand results in an increase in SPX options premiums, which is quantified by a measure known as implied or expected volatility. The VIX tracks this expected volatility. For that reason, the index has been dubbed a “fear gauge” because it rises during periods of market uncertainty and falls when investors are sanguine about the outlook for the US equity market.

In mid-August, amid extreme investor angst surrounding the conditions in the credit markets, the CBOE Volatility Index jumped to a multi-year high of 37.5. By way of comparison, the VIX started the year near 12 and began the month of June at roughly 13. However, by mid-July, when the Dow was climbing to new all-time highs above 14,000, the volatility index had already begun moving higher. It was, in fact, sending a warning signal to investors that, despite a fresh peak in the Dow, higher levels of volatility were forthcoming. The volatility index was near 16 when the stock market started to falter in mid-July, and 3.5 points above its early June lows. Then, as the Dow fell from its high and stocks suffered the one-month setback, the VIX continued its ascent until hitting 37.5 on August 16, or its highest levels since October 2002.

Just as in mid-July, when the Dow was making its first climb above 14,000, the VIX might once again be sending out a warning signal. Over the past week, the Dow Jones Industrial Average rose during three of five trading sessions, including a 99-point gain last Wednesday and the 191-point advance that pushed it back above 14,000 on Monday. It is up 278 points from a week ago. However, while the Dow has moved solidly higher, the VIX (at 18.90 midday Tuesday) is at the same levels it was one week ago. So, despite an impressive one week rally that pushed the Dow to new all-time highs, the market’s “fear gauge” is not falling.

The lack of movement in the VIX is perhaps sending a cautious signal that it is premature to conclude that the Dow’s new highs is a sign that all of the problems from the summer months have gone away. It might be dangerous to assume that we can expect a return to a normal market environment similar to the one witnessed during period before the volatile summer months, when the VIX stayed in a range between 12 and 14. In other words, if the recent 280-point rally in the Dow Jones Industrial Average is based on the notion that the worst is over and the market is going to see a return to normalcy in the fourth quarter, the VIX is not yet on the same page.

So, if the VIX is straying from its normal pattern, just as it did in June before market volatility spiked off the charts, and the divergence signals that the stock market is at risk of further damage in 2007, what can investors do? One possible hedge, or protective play, is to buy calls on the VIX that expire in 2008. If market volatility returns, the VIX is likely to move higher as well and the calls will increase in value to create profits and/or offset losses in stock portfolios. On the other hand, defensive plays on some of the market indexes or ETFs can also protect investors should the stock market take another turn south. For example, puts or bear put spreads on the S&P Depositary Receipts (), the Dow Jones DIAMONDS (), the Dow Jones Industrial Index (), or the S&P 500 Index will protect stock portfolios is things go haywire. Alternatively, investors can isolate specific sectors of the market that are at risk. For example, if an investor is concerned about the credit markets and the impact on the financial sector, bearish trades on the Select Sector Financials (), the PHLX Bank Sector Index (), or the AMEX Broker/Dealer Index () might also make some dollars and cents.

Frederic Ruffy
Senior Writer & Index Strategist
Optionetics.com ~ Your Options Education Site
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