Does Volatility Matter?

If you have been paying attention to the financial markets and media across the last few weeks, we are sure that you have heard a lot about the “VIX.”

While many investors are familiar with this metric, there are many for whom it is a new concept.

The “VIX” is the “Chicago Board Options Exchange Volatility Index.”

It is designed to be an up-to-the-minute measure of investors' expectations for volatility, using the midpoint of the real-time S&P 500 Index options bid/ask spread.

For our purposes, the calculation doesn’t matter so much. The VIX is a measure of volatility that also captures the amount of “fear” in the stock market.

We published this chart earlier this week, but here is a chart of the VIX going back twenty-five years…

Historically, it has traded between a range of 9 and a high of almost 83 during the height of the COVID period.

You can see that the VIX trades between 10 and 20 most of the time, with brief spikes higher during periods of market volatility.

However, when we enter a full BEAR MARKET, the VIX can move MUCH higher.

As an investor – how should you look at the VIX and incorporate it into your TRADING or INVESTING?

In many ways, the VIX is like one of our favorite technical indicators, the relative strength index (RSI).

The VIX – as a measure of fear – is the inverse of the RSI numerically. A high VIX indicates much fear in the market, while a low VIX implies much less fear. RSI is the opposite.

Most of the time, the VIX (and RSI) don't tell us much about what is going on in the stock market. They don't help give any actionable insight into the probabilities of what may happen next.

Some would say that a low VIX implies a level of complacency among investors and potential danger.

Factually, this is incorrect.

The stock market experiences its biggest losses during periods when the VIX is high for an extended time.

When the VIX is very low for an extended time, it correlates most highly with a strong BULL MARKET. The longer the stock market runs, the lower the level of the VIX.

This is why we think a low VIX is not a helpful variable. It does not provide real insight into what will happen next in the stock market.

As we mentioned above, a very high VIX often correlates with a BEAR MARKET. However, that is only true when the VIX is high for an extended period.

As a rule, if you are in a multi-month period when the VIX is above 25 or 30, we recommend that you modify your trading strategies to those geared to BEAR MARKETS.

In this way, the VIX can help investors understand the stock market's overall backdrop.

There is a time, though, when the VIX is MUCH more useful. That is when it moves higher quickly!

Just like RSI, even if a company's fundamentals are terrible if it gets to certain levels of "oversold", it will almost always bounce back. The “almost” is because sometimes companies go bankrupt.

You know what doesn’t go bankrupt? The overall stock market!

In this sense, you can use large spikes in the VIX as potential stock market entry points.

We have profitably traded in every BEAR MARKET for the last thirty years. One key to our success has been buying into stocks as the VIX has risen to extreme levels.

One way to look at it is not the absolute level of the VIX but its change—especially over a short period of time.

This is basically the RSI calculation.

If you see extreme spikes in the VIX, they are often buyable.

If they happen in the context of an established BEAR MARKET and an extended period of a heightened VIX, then you want to be careful with how you trade the market. That doesn't mean it doesn't work – you need to size your positions accordingly and understand your risk tolerances.

What happens if you see a big spike in the VIX and it is NOT an established BEAR MARKET?

That is what happened just a few weeks ago.

That can be a very BULLISH signal. Especially if you see a dramatic drop in the VIX afterward.

Here is a great post from Charlie Bilello recently on X/Twitter…

You can see here that he points out that when you see a massive drop in the VIX, as we have just seen that the stock market is higher one year, two years and three years later 100% of the time. It also has gone up more than normal for these time periods.

Maybe this time will be different, but we think that this is a pretty good data set historically.

Like many technical indicators, the VIX is not very useful much of the time.

When it IS useful, however, it can be a game changer and worth you understanding how it works.

Do you use the VIX as a potential TRADING signal? Let us know at [email protected] or in the comments section online.