Don’t Be Afraid of the “Fear Index”

The market’s “Fear Index” rallied hard on Friday, leading some to question whether 2011 is going to be another banner year for volatility. But for traders, an upswing in volatility and fear is actually a good thing – here’s a more in-depth look at the VIX, and how you can use this “Fear Index” to your benefit in the coming year.

Before 2008, the VIX wasn’t a household name for most retail investors. But as the index, which measures the implied volatility of the S&P 500 index, rose to new highs amid the crumbling stock market, this unique index got more than its fair share of attention. That said, ask even the most fervent market observers what the VIX really is, and you can expect answers to diverge a bit…

So, what exactly is the VIX?

The VIX’s full name is the CBOE Volatility Index. Essentially, this measure of volatility was created in 1993 for the Chicago Board Options Exchange (CBOE) by then Duke University Professor Robert Whaley to represent the market’s expectation of market volatility for the next 30 days.

Simply put, the VIX is a good indicator of just how much investors can expect prices in stocks to swing. A higher number means bigger moves (both up and down), whereas a smaller number indicates smoother sailing ahead…

But the VIX is actually designed to tell us much more than that – the value of the VIX is actually significant too. It tells us the expected movement of the S&P on a percentage-point basis.

Let me explain…

As I write this, the VIX sits at 19.46. That number is the expected annualized price movement of the S&P 500 in the next 30-days. By digging up a bit of finance class math, that tells us that right now investors are expecting the S&P to move 5.48% (either up or down) in the next 30-days. Although that’s a potentially large percentage move, it’s still far from game changing volatility.

That said, there’s another element of the VIX to look at – where it’s headed:

Taking a look at the chart above, a few things are clear about the VIX’s price action. For starters, the index has been trading in a downtrending channel. And for another thing, it looks like the VIX is finally finding support near its 52-week low of 15.23. With Friday’s test of channel resistance, a change of trend could be underway for the VIX.

For traders, that could be a very big deal – especially if volatility moves back toward previous highs:

• In May, the VIX hit a near-term high of 48.2, which suggests expected single-month moves of 13.9% in the S&P 500… That’s major volatility.

• In October 2008, the VIX hit a blistering all-time high of 96.4. That means that the markets were pricing in monthly expected volatility of 27.8%!

From a technical perspective, every time the VIX has tested support in the low 15 range (weekly), the index has bounced back significantly higher. Since the last few weeks have been another retest of 15 (see the chart above), that’s indicative that higher volatility may come back into play.

If that’s the case, it’s going to be crucial to wait for a broad trend in the S&P 500 and Dow before jumping into stocks. Remember, the VIX indicates movement in either direction, so unless an uptrend is defined, stocks can just as easily move lower.

Obviously, this is a theme we’ll be keeping a close eye on in 2011…

Cheers,
Jonas Elmerraji
Penny Sleuth

February 1, 2011

Don’t Be Afraid of the “Fear Index” was originally featured in the Penny Sleuth. Check out Wall Street’s 5 Most Profitable Penny Stock Patterns Report.

This story was originally featured on Penny Sleuth.

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