The VIX, the Market, and the Investor

I know this title sounds like it could be a Chronicles of Narnia sequel, but the relationship between the VIX and the market is more than just a fairytale. You've heard me mention that the VIX is the volatility index, but exactly what is it and what does it tell us? Technically, the VIX is the measure of volatility on the S&P 500. It's an invention of the CBOE (Chicago Board of Options Exchange) along with their other volatility products that cover these benchmark indices: Dow Industrials-VXD, the Nasdaq 100-VXN, the S&P 100-VXO, and the Russell 2000-RVX. (Note: There's also a volatility index on crude oil, the OVX.) The VIX and its brethren reflect the market's expectation of 30 day volatility and are constructed using the implied volatilities of calls and puts on a wide variety of near-term index options. Just like the standard deviation of a rate of return, the VIX is quoted in percentage points. As of this writing, the VIX is trading at 28.81, a relatively high value.

The Vix and the market
The VIX is regarded as a leading barometer of investor sentiment and inherent market risk. It is negatively correlated* to the S&P 500, meaning that if the VIX moves higher, the S&P will move correspondingly lower. The monthly chart of the VIX and the S&P below shows this to indeed be the case. You can see that during bull markets, the VIX stays low. The 90's bull market was marked by a VIX that stayed in the low 20s. The latest bull run from 2003-2007 had VIX values in the 10 to 15 range. Why the difference? Pre-2003 the CBOE derived the VIX from the implied volatilities of only eight at-the-money put and call options on the S&P 100. Since then, the VIX has expanded to use more options based on the S&P 500. This allows for a more accurate view of investors' expectations on future market volatility which is reflected in the chart.

How to use the VIX
Okay, so now you know what the VIX is and what it represents. But how can you, the investor, take advantage of it? For one, you can use it as a strategy guide for your own investing. For example, last July the VIX broke through its upper level resistance of 20 and stayed there. What the VIX was telling us was that people were starting to get jittery. That was the time to lighten up on long positions and start using protective strategies such as stock and index puts. Since then, the market tumbled while the VIX rode higher. The chart below shows the VIX making a series of higher highs and higher lows, with each low bouncing off its 20dma (not shown in the chart). The lows formed a perfect trend line that was subsequently broken on April 1st when the market reversed course and began heading up. But unfortunately, the rally was short-lived. The VIX traded below 20 for a month before it turned back up trading through the 20 mark at the beginning of June. And as we well know, the market has been skidding downhill since.

Several years ago, the CBOE began offering options on the VIX. (There are VIX futures, too.) The options are liquid but they're also volatile. Used appropriately, they can reduce portfolio risk while maintaining returns. (For further info click on the CBOE link below.) This is their conservative side. If you have a speculative streak, you can play them as you would any other option but I'd be extremely careful; the implied volatility on these options can be high. In other words, the volatility index is a volatile index. Buying puts at extreme highs could land you a tidy return in a very short amount of time. I haven't done this so I can't put the Dr. Kris seal of approval on it, but next time the VIX heads north of 30 (which it's threatening to do any minute), I might just take on a small position and see how it works out.

VIX Strategies
You may wish to take note of the following strategies based on VIX movement:

Falling below 20: Start covering short positions and bias your portfolio towards the long side. As the VIX drops, keep adding to long positions.
Staying below 15: Utilize all bullish strategies, including more aggressive plays.
Rising above 15: Use covered calls to protect long positions. Wait until the VIX falls below 15 before initiating new long positions.
Rising above 20: Start unwinding aggressive positions. Collar long stocks if you're planning on keeping them. Start buying stock or index puts. (Can also buy VIX calls as another portfolio hedge.) If VIX remains above 20, lighten up on long positions.
Rising above 25: Cash out of long positions if possible or fully protect the ones you keep. Enter short positions or buy Contra ETFs.
Rising above 30: If you have short positions, starting writing covered puts.
Near or above 35: The market is ready to capitulate. Speculators can buy index calls or VIX puts. You'll have to be on your toes to catch this one as the VIX kisses this level for only a moment.

What is the VIX telling us now?
The above chart shows that the market doesn't turn around until the VIX reaches the mid-30s (typically 35). The VIX hasn't even reached 30 which to Dr. Kris's eyes means continued market decline.

Summary
I hope I've given you a better picture of the VIX. Unlike the wardrobe in the Chronicles of Narnia, there's no magic behind it except in how you use it and for that, the wand to make your portfolio returns grow is in your hands. May the power of the VIX be with you!

*The CBOE lists the VIX/SPX correlation coefficient at -0.86 (current as of June 2007) which is a high measure of negative correlation. (+1 is perfect positive correlation; -1 is perfect negative correlation; and 0 is no correlation)

Reference: Using VIX options to reduce portfolio risk: http://www.cboe.com/micro/volatility/introduction.aspx