By Kapil Mokashi, CMT, CFP
Decoding the VIX – The Fear Gauge
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Decoding the VIX – The Fear Gauge
VIX, or the volatility index is often referred to as the fear gauge and one the most widely followed sentiment indicators by traders and investors alike. Beginners often find VIX a little confusing because of its contrarian nature. In this short article we will try to understand what VIX is, the role it plays in financial markets, and its relevance for traders and investors.
What is the VIX?
The VIX is an index created by the Chicago Board Options Exchange (CBOE) that measures the market’s expectations for volatility over the next 30 days. It is derived from the prices of S&P 500 index options, offering a forward-looking estimate of market volatility.
Tracking the VIX –
Market participants keep a close eye on VIX as it is often considered a real-time market sentiment gauge. A rising VIX usually suggests that investors are seeking protection against potential downturns, reflecting growing fear or uncertainty. Conversely, a low VIX indicates complacency or confidence (or say over-confidence) in the market. These very emotions open up opportunities for traders and investors. You may wonder, how? Well, VIX has predictive power. Historically extreme levels in the VIX have been associated with huge market reversals, either signaling a bottom during market panic or indicating a potential top when the VIX levels are unusually low. Thus, Savvy investors and traders position themselves on the buying side when the VIX levels are unusually high and there is sheer panic in the markets, as It is only during panics you get the stocks at throwaway prices. This is where bottoms are made. Similarly, professionals will look to be extremely cautious, stay aside or build short positions when VIX is at historically low levels, as historically low levels of VIX are often associated with complacency as markets keep on hitting newer highs, shrugging of all the negative news. This is where even undisciplined traders are rewarded, as they carry overnight positions without hedge or keeping a stop loss expecting the rally just to continue from where it closed. Unfortunately, this is where the small retail traders/investors get trapped, are caught unawares and professionals take full advantage of them. I would like you all to remember a simple thumb rule while reading the VIX and that is, “When VIX is high, it’s time to buy, & when VIX is low it’s time to go”
The obvious question then is, what is high or low? There is no sacrosanct number for this, but historically VIX levels greater than 30 are generally linked to huge volatility, market panics, and uncertainty, whereas VIX levels below 15 and more prominently in single digits are associated with extreme complacency, calm, and composed periods. One important point to note here is, only a standalone level of VIX won’t give a clear signal to buy or sell. If VIX crosses 30 it would be naïve to expect that markets will fall immediately and vice-versa. This is because VIX has a tendency to stay in a range for a long time without giving any bullish/bearish signals on price charts. For eg Vix may continue to remain around the levels of 15 or 14 and markets may continue to move up for an elongated period. Thus, extreme high levels of VIX should be used as a buying opportunity, only when price chart gives an equivalent confirmation. This confirmation can come from huge volumes at a support levels, a bullish candlestick pattern at a strong support level (like an engulfing bull or a hammer), historically low levels of RSI (levels below 20) suggesting oversold markets. Similarly, extremely low VIX should be confirmed by accompanying bearish signals on the price charts
Now that we have understood the VIX in detail, let us try and see some real-world examples of VIX levels and their impact on stock markets. Here we will compare VIX with S&P 500, widely regarded as the best gauge of large-cap US equities. We will compare the periods of extreme volatilities in VIX, especially in the recent past & the accompanying price charts around those levels.
March 2020 S&P made a record low & VIX hit a historic high of 86
Oct 2022 S&P made a bottom with a strong engulfing bull & on the same day VIX hit a high of 38
Very recently in August 2024, S&P made a low of 5120 and on the same day VIX hit a high of 65, highest level in last couple of years
To summarize, the VIX is more than just a number; it’s a reflection of the market’s collective psyche. For traders and investors, keeping an eye on the VIX can provide valuable insights into potential market shifts. While it’s not a crystal ball, understanding and interpreting the VIX can help navigate the complexities of the financial markets, allowing for more informed decisions during periods of uncertainty. Remember the golden rule – When VIX is high, it’s time to buy, when VIX is low it’s time to go”
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Originally posted 30th August 2024
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