Using The VIX To Gauge Market Sentiment

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So, how’s it measured?  The answer to this is a bit more complicated. Entire white papers have been authored on this subject.  I could spend hundreds of pages describing in detail the theory and thought behind the VIX.  So here’s the short version.

The VIX takes a basket of options looking about 30 days into the future. Then a measurement of the changes in value of puts and calls is made. Taking this data, and a fancy algorithm, they’re able to calculate the price of the VIX.  Using today’s computer technology the calculations are done continuously throughout the day.

I know that’s confusing.

What you really need to know is this.

The VIX is a measurement of “Fear and Greed”.  When investors become fearful, they tend to pay more for options.  This makes sense.  Buying and selling options are an easy way to hedge your exposure to the market.  When investors are fearful option prices increase and the VIX goes up.

Take a look at this chart on the VIX for the first quarter.



The volatility in the last few months has been crazy.  Investors are fearful.  Look at the blue line.  It’s a moving average over the prior 50 data points.  See how it suddenly angles up and to the right.  This shows that investors became really fearful – starting in July of 2007.

You know as well as I do the Dow was over 13,600 at that time. Everyone knows what’s happened since then.  The Dow fell to 12,000 over the next few months.

Historically, when values on the VIX are greater than 25 the markets are unsettled and investors are fearful.  The last time the VIX was above 25 was in 2002 . . . and we all know what was happening in the markets then.  When the VIX is below 20 the markets are relatively calm.

Now I look at the VIX every once in a while to get a grasp on market sentiment.  I’ve noticed something recently.  In the last few months the VIX has been heading lower.  As a matter of fact, it’s fallen almost 45%.

This tells me that investors are becoming less fearful.  While never a perfect indicator, it could lead to higher levels in the major market indices in the coming months.

As a result, I’m cautiously optimistic about an intermediate term rally in the markets.  Possibly starting as soon as this fall.

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