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Measuring the Mood of the Markets

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One of the most important facts to understand about market action is that it is driven by investor psychology. In fact, it has been said that the stock market is a barometer for fear or complacency about the economy, where measurements are taken in terms of dollars gained and lost.

Knowing that investor psychology is a dominant factor in the financial markets is a necessary, but not a sufficient condition for successful investing. The other tool that traders need is a method for measuring the emotions of other investors as a group. Fortunately, the Chicago Board of Options Exchange (CBOE) has provided us just such a tool in the form of the Volatility Index, or VIX.

The VIX is a sentiment indicator that is calculated using the implied volatility of the eight most heavily traded front month put and call options on the S&P 100 index (OEX). Recall that the VIX typically moves in a contrary manner to stock prices. As prices rise, the VIX falls, and vice versa.

While most of us know that the VIX has a 'normal' range in which it trades, giving buy signals above 30 and sell signals near 20, that knowledge doesn't really address the underlying importance of the indicator. When the market is falling, traders buy more puts than calls either to protect open long positions, or as speculation that the market will continue to fall. As the market declines further, increasing levels of put buying drives the VIX towards the high end of its range by increasing the ratio of puts to calls, confirming the increased fear in the market. Conversely, when the market is rising, investor enthusiasm drives them to speculate with calls, decreasing the put/call ratio. The cycle feeds on itself, driving the VIX towards the lower end of its range.

Since we talk about the action of the VIX so frequently, especially in the LEAPS column, I thought it would make sense to look at the action of this indicator in detail. Analyzing historical behavior in the market helps us to both profit from patterns that tend to repeat, as well as avoid repeating mistakes we may have made in the past.

We have all seen long periods of time where the VIX can hover near one of the extremes of its range for weeks and months at a time without a corresponding move back in the other direction. Then all of the sudden, it (and the market) reverse directions and give us a very tradable rally (or decline). Then during extreme movements in the markets, the VIX may stay outside the normal 20-30 range for weeks or even months at a time.

What this demonstrates is that peaks and troughs in volatility are not discrete events, but should instead be viewed as a process. I went back to a couple of historical peaks in volatility that I think demonstrate this process; first in late 1998 and then the first half of 2001. Note the similar behavior demonstrated as the VIX pushed through the upper end of its normal range near 30.

Starting with the 1998 case, we can see that the VIX began probing above the 30 level in early August, but fear didn't really take hold until nearly a month later when the VIX finally broke decisively above 30. After that point, it took 6 full weeks for the 'fear index' to reach its peak near 60 on October 8th. With that kind of blowoff, the markets reached an unsustainable level of fear driven both by the 'Asian flu' currency crisis and the collapse of the Long Term Capital Management (LTCM) hedge fund. Not only was October 8th the peak for the VIX, but it also represented the low for the broad market as measured by the S&P 500 (SPX.X) or the S&P 100 (OEX.X). As investors determined that neither of the macro-economic events listed above would cause a national economic disaster, they started behaving in a more bullish manner, buying stocks (and calls) and this led the VIX back down to the 30 level by the end of the month. Once the VIX moved back into the 20-30 range in late October, the broad market had gotten a nice start on the next leg of its great bull run that lasted into the following summer.

The picture for the VIX was very similar earlier this year, although the cause was very different. As the economy continued to weaken, investor fear started increasing throughout the month of February and the VIX shot began pushing above the upper end of its typical range. The real breakout didn't take place until mid-March, and that set the stage for more than 6 weeks of exceedingly volatile trade in the markets, culminating with the completion of a double-top in early April. Once again, the final VIX peak near 40 on April 3rd coincided with a near-term market bottom, from which the bulls were able to stage a solid 7-week rally.

We can't use the VIX alone to make our trading decisions, but it can certainly provide a powerful confirmation of the extremes in the market. So let's take a look at more recent action and see what the VIX is telling us.

After the inflection point seen in late August, the market was already in decline before the September 11th terrorist attack, and that event was simply the catalyst to hasten the spike in fear measured by the VIX running as high as 58 in late September. The sharp decline in the VIX that followed over the next few weeks came at the same time that the SPX rallied well off its lows. Then most of the month of October, showed a coiling action, with the SPX refusing to sell off under support, while the VIX failed to break resistance in the high 30's. Simply put, the bears were unable to stampede the bulls into another selling panic, and that situation naturally resolved itself with the market rallying through resistance and the VIX falling back into its historical range.

Over the past few days, we've seen some profit taking in the broad market, but important support levels are holding, indicating there is certainly not a rush for the exits -- all we have here is some healthy profit taking ahead of the holiday weekend. This is confirmed by the declining fear in the markets, as the VIX continues to work towards the lower end of its traditional range, even on negative market days. Barring another terrorist attack, or equally fear-inducing event, it appears that the VIX will continue falling towards the 20-22 area before we see a meaningful reversal in sentiment.

The really important point here is that the extremes in the VIX consistently telegraph high-odds buying opportunities. We have to endure some volatile market action in the weeks that follow the extreme, but history demonstrates that these times can provide outsized returns for those with above-average intestinal fortitude.

There are other sentiment indicators such as the Put-Call ratio and the TRIN, and each has their own advantages and disadvantages. No single technical indicator can tell you everything you need to know to trade a given financial instrument, but if you trade the SPX or OEX (or any of their major components), then using the VIX along should allow you to act rationally when the crowd is paralyzed by fear.

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