Over the last several days, the VIX has started making new all-time highs. In this entry, we will describe the VIX and how to interpret it.

Skipping ahead to the conclusion: As an inverse indicator, a high VIX usually indicates an excess of pessimism in the markets — followed by stronger equity prices.

Background

The CBOE Market Volatility Index (VIX) was developed in 1993 by the Chicago Board Options Exchange (CBOE). It is a benchmark for expected future stock-price volatility and investor sentiment. The VIX measures the market’s expectation for near-term volatility — specifically, volatility expected during the next 30 calendar days (or 19-23 trading days, typically).

Description

The VIX is based on real-time option prices, which reflect investors’ consensus expectations of future stock market volatility. The expectation of pending market declines equates to higher option prices, and translates as investor pessimism or financial stress. Thus, the VIX tends to rise on pessimism. As expectations of future market declines subside, option prices also decline, driving a concurrent decline in the VIX. That said, the VIX is designed to track market volatility itself — it says nothing about the price or value of any underlying security per se.

Interpretation

The VIX should be read as an inverse indicator of investor sentiment. High values imply pessimism about the next 30 days and a probable decrease in options prices; low values imply optimism and an increase in option prices.

The VIX essentially indicates the going price of “stock market insurance.” The higher the VIX, the more investors are willing to pay for options that insure against declines in the S&P 500. (The VIX used to measure index options for the S&P 100, but was rebalanced to measure options on the S&P 500 in 2003.)

So when the indicator spikes or is at the high end of a historical range, it indicates (i) that investors are willing to pay large amounts for call and put options, and thus (ii) are unusually pessimistic (relative to the historical trend of investor sentiment). For these reasons, (iii) there is probably increased volatility ahead -— as a spike or new high indicates an extreme in the markets (an extreme in sentiment); and (iv) we should expect much of this volatility to be to the upside, because of the extreme degree of negative sentiment (pessimism) implied by a spiking VIX.

Excessive optimism in the VIX favors a growth strategy; excessive pessimism, as we are seeing now, a value strategy. (Though in our opinion, it is worse than useless to shift your style allocation based on short-term VIX readings. Rather, one might add or subtract positions in value or growth stocks at the margin based on the indicator’s reading.) Most of the time, of course, the indicator is in the middle range — not at any extreme. Such ambiguous readings favor a tilt toward index-based strategies consistent with the idealized business cycle model. Finally, the VIX can also be used as a component in managing the portfolio’s derivatives strategy, as a broad indicator of the price of call and put options.

Current Reading

As mentioned, the VIX is currently spiking to all-time highs. Specifically, it is at 44.26 as we write, up 11.3% for the day. It has maintained levels this high only three times before: in mid/late 3Q02, in 3Q97, and in 3Q96. (Those third quarters are tough.) And it has never been higher than it was on Monday, when it spiked to an intraday high of 48.40. On all three previous occasions, the S&P 500 rose sharply in the following months and years.

But it’s not a perfect predictor: Spikes in the VIX that, at the time, would have been interpreted as excess pessimism (expected to be followed by stronger, mean-reverting equity prices) have on occasion proved misleading — though never from levels as high as the VIX is now. One such “head fake” occurred following the September 11 operations. The VIX spiked briefly at 43.74 before closing substantially lower (at 31.93). On that occasion, the market did not start to rebound until early in the fourth quarter of 2003 — a year and a half later. Then, as now, the market had been falling for over a year. But even following 9/11, the VIX did not maintain levels anywhere near where it’s been trading recently or on the previous three occasions referenced.

There is no single indicator, including this one, that is sufficiently robust to justify a strategy shift. What’s more, the optimal allocation to equities over the past year, at less than 5%, has been much lower than most investors’ minimum constraints.

So if you have no allocation to stocks, you might consider wading into the market with a large-cap, value-focused, dividend-oriented equity strategy over the next several months. But chances are you already have far too heavy an allocation to this single asset class (stocks). In which case you might consider selling out-of-the-money puts after the market has started to rebound, as the excessively pessimistic VIX indicates it might.

Short Put Strategy

Shorting out-of-the-money (OTM) puts allows you to buy the underlying stock below its current market price, in the event that it declines to (or below) the option’s exercise price. If it does, you are obligated to buy the stock — but at a discount to where it is when you sell the put. If the stock does not decline to the exercise price, the put option expires worthless and you keep the premium generated from having shorted it. If the stock just rises and rises, then you never buy the shares and just keep the premium — possibly profiting less than if you had simply bought the stock. We are in a down-trending market that the VIX indicates may be due for a reversal. Thus, the naked OTM put strategy generates immediate income, lowers your entry price, and even provides some upside in the case of a sharp, upward market reversal.

Disclaimer

Don’t take our word for it. Not taking investment advice from anyone who publishes anything on the Internet is generally a good idea. If you haven’t been trained to manage money then pay an established professional to do it for you, using resources like this one to help him help you. You can read our full disclaimer here. ♦