Let’s start off and define what it means when you hear about “volatility”. Since this topic has been discussed at length by many people smarter than I am, I see no reason not to let Marty Chenard of Stocktiming.com discuss it:
“The Volatility Index (or VIX) is a weighted measure of the implied volatility for real time $SPX put and call options. The puts and calls are weighted according to time remaining and the degree to which they are in or out of the money. From this is created a hypothetical at-the-money option with a 30 day expiration time period. In this way, they are trying to set a value that is equal to the equivalent value of the $SPX's current price. (When a stock's option strike price is "at the money", it is theoretically the same as the price the stock is trading for at that moment.) So what does that mean? It means that the VIX really represents the "implied volatility" for the hypothetical $SPX put/call options on an "at the money" option value.
Let’s use a brief, more understandable explanation:
The VIX is a key measure of market expectations in the near term. For almost 20 years, the VIX has been considered as a valuable barometer of investor sentiment and volatility. Another way to look at it, is that it measures perceived risks of investors. The greater the perceived risks investors have about stocks, the more they buy "protection Put options", which means that the VIX will therefore be moving higher. When the VIX moves higher, the market moves lower because they are inversely related.
Many talk about the VIX's implied volatility changes ... but, don't get caught up about the term "implied volatility" if you don't understand it. What is important is that the VIX moves up during times of uncertainty or fear, and down during times of greed or confidence. Since the VIX moves in the opposite direction of the market, you can know what to expect for upcoming market movements by observing what is happening to the VIX. If you think about it, the VIX is a good example of "the self fulfilling prophecy". (The definition from Wikipedia is: "A self-fulfilling prophecy is a prediction that directly or indirectly causes itself to become true, by the very terms of the prophecy itself, due to positive feedback between belief and behavior.")
How does it work as a self-fulfilling prophecy? Imagine that an investor has bought a lot of equities over time and now believes that market risks are rising, so he feels that it would be wise for him to buy protective Put options in order to protect his equity. If he believes the market risks are truly rising, he not only buys the Puts, he also stops buying ... otherwise it would be counter-productive. The mere action of enough large investors stopping their buying is often enough for the market to be unable to sustain its up movement. Thus the market pulls back a the self-fulfilling prophecy event occurs.
**NOTE** Since investors have to buy options expiring in the future in order to protect themselves from their perceived beliefs about upcoming changes in the stock market, those actions cause the VIX to move ... and the VIX's movement therefore measures investor expectations of what they believe will happen in the near future. That's it ... this is all you need to know about what the VIX really is.
Since the VIX reflects the actions of investors who buy options as insurance against losses on their current portfolio positions, it would suggests that the VIX's action is predicated on the actions of some very knowledgeable, as well as some very large investors.
So, should you learn more about the VIX and use it ... or not? Here is what you need to ask yourself and decide about: Is the VIX a reliable measure for me to use in determining what will happen to the stock market or not?
If it isn't, then simply disregard it and do NOT use it as an important tool for making investment decisions. HOWEVER, if it is, then you MUST consider using the VIX as a tool when making investment or trading decisions.
I know that you cannot answer this question without also knowing how the VIX tracks with the Stock Market, and how to use the VIX in an effective manner.
How to Use Technical Analysis on the VIX to know when the market will change direction.
Since the VIX moves in the opposite direction of the market, we commented that one could know what to expect for upcoming market movements.
But we also said, ... that is only if the VIX is a reliable tool for determining what could happen next in the stock market. So, what is the correlation between the VIX, the Stock Market, and other indicators? Further, Is there sufficient correlation between the VIX and the Stock Market?
The answer is NO if the VIX is used alone. Most investors are just not cognizant of the fact that when they are investing or trading ... they are trying to compete with Goldman Sachs and other large Wall Street firms. These firms use a multitude of programs and tools to hedge, sell against hedging, and to initiate clean buy's into the market.
There are some critical factors that are involved when the VIX is moving up or down. If anything, they will show you WHY you should not rely on the VIX by itself.
When Wall Street players hedge or play the market, the NYSE Down Volume (Symbol: DVOL) is always a factor with what is going on with the VIX. So, the first thing to do is look at the 4 possible VIX to DVOL combinations that can occur, and what they typically mean for the market movements.
Here they are ... this chart shows the 4 major possibilities for various VIX and DVOL combinations. As you can see, there are really 2 important possibilities for investors, and that is when the VIX and the DVOL are going in the same direction ... whether up or down together. (When they are going in opposite directions at the same time, one is offsetting the other which influences a sideways market move.
Between April to August of 2011, there were 6 times where 1 of the 4 possible conditions occurred. Below is the matrix showing the VIX to Dvol combinations that occurred on the chart above and their resulting market action.
So, what helps to determine how large the SPY move is or isn't? ... or what helps determine how long a move will last? A significant part of the answer has to do with how much Institutional Investor Selling is occurring at the same time.
At the beginning of August, the VIX and the Dvol both peaked. Even though the VIX peaked, many people were not sure if the VIX was going to continue in an uptrend or not. The answer came just after 48 hours had passed because the Institutional Selling shifted to a down trend. Indicator tools like Institutional Selling are important for understanding what is really going on in the market, and why an isolated indicator like the VIX can't tell the whole story by itself.
Tools like these indicators are important parts to the whole equation, but still they don't tell the complete story. It is always better to try to gather as much information as possible in order to see what the Institutional Investors and Wall Street firms are doing.
These days, a good part of investing sensibly is to never go against what the Institutional Investors are doing. The days that a smaller investor can win when going against what the big Institutions are doing are few and far between.”
Sorry for the length of this post, but this is important. All of this volatility is increasing the risk of being in the Market! Are the potential rewards adequate to compensate you for this risk that you’re taking on?
The European situation remains dismal. The U.S. is running huge deficits in a moribund economy and the Fed has essentially used all of their silver bullets to stimulate the economy. In fact, many people are arguing that they have over-stimulated the economy by printing so much new money that we will eventually have to pay the piper through some serious interest rate increases or suffer through inflation. Emerging economies are also over-heating and are dealing with their own economic problems.
My point is that given the global situation, I do not believe that the Markets can adequately reward you for this additional risk. This is why I’m remaining predominantly in cash.
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