The VIX Index >>> What It Is About

The VIX is often referred to as the "Fear Index".

Although a high VIX does not represent a definite bearish signal on stock, the market fluctuates most during times of uncertainty. Historically, VIX hit its highest points during times of market turmoil and financial downturn.

The VIX aka volatility index is an index which measures expectations of volatility, or fluctuations in price, of the S&P 500 index or the Dow Jones Industrial Average. Higher values for the volatility index indicate that investors expect the value of the S&P 500 or DJIA to fluctuate wildly - up, down, or both - in the next 30 days.

What Is Volatility?

Volatility is the rate at which the price of a certain [security] moves. A security with high volatility has bigger fluctuations in price compared to a security with low volatility. The more quickly a price changes up and down, the more volatile it is. As such, volatility is often used as a measure of risk.

For example: A stock whose price went up 10% yesterday and went down 25% today is more volatile than a stock which increased 2% in both days.
Volatility can be observed by looking at past changes in stock price. The standard deviation of percentage changes in price is used used to calculate observed volatility.

Mantra Maxims : One of the earliest mantras investors will learn in relation to the VIX is "When the VIX is high, it's time to buy. When the VIX is low, look out below!"

"Long ago, Sir Isaac Newton gave us three laws of motion, which were the work of genius. But Sir Isaac's talents didn't extend to investing: He lost a bundle in the South Sea Bubble, explaining later, 'I can calculate the movement of the stars, but not the madness of men.' If he had not been traumatized by this loss, Sir Isaac might well have gone on to discover the Fourth Law of Motion: For investors as a whole, returns decrease as motion increases." >>> Warren Buffett.

Figure 1 attempts to identify various support and resistance areas that have existed throughout the VIX's history, dating back to its creation in 1997. Notice how the VIX established a support area near the 19-point level early on in its existence and returned to it in previous years. Support and resistance areas have formed over time, even in the trending market of 2003-2005. When the VIX reaches the resistance level, it is considered high and is a signal to purchase stocks – particularly those that reflect the S&P 500 and the Dow. Support bounces indicate market tops and warn of a potential downturn in the S&P 500 and the DJIA.

Derivatives During Decoupling

While it is rare, there are times when the normal relationship between the VIX and S&P 500 change or "decouple." Figure 2 shows an example of the S&P 500 and VIX climbing at the same time. This is common when institutions are worried about the market being overbought, while other investors, particularly the retail public, are in a buying or selling frenzy. This "irrational exuberance" can have institutions hedging too early or at the wrong time. While institutions may be wrong, they aren't wrong for very long; therefore, a decoupling should be considered a warning that the market trend is setting up to reverse.

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