How the “Fear Index” Helps Us Trade

In today’s issue, I wanted to take some time to answer a reader’s question on technical analysis.

Here’s what he has to say…

What is the magic number for the VIX to watch? Is it 30? As a guide?

– Robert L.

Hi Robert, thanks for writing in.

A trader’s main goal is to figure out where a stock (or index) might be headed next… and to capture some of that move.

And the CBOE Volatility Index (VIX) is a great tool to forecast what might lie ahead. It’s often referred to as the “fear” index.

The VIX often indicates when the market is heading for a fall.

And while most forms of analysis focus on past trends (like historical information and prices), the VIX is forward-looking.

It gauges what traders are expecting the market to do in the next 30 days.

The VIX measures the volatility of the S&P 500 using index options. The higher the VIX is, the higher the expected volatility will be over the coming month.

Generally speaking, a VIX below 12 is low. A “normal” range is between 13 and 19. A VIX over 20 is a high reading.

So when the VIX rises to 30 or greater, the market is pricing in very high volatility, increased uncertainty, and lots of fear from investors.

Let me explain…

How the VIX Gauges Fear

When traders think the market will rise, they buy call options. And when traders get nervous about a potential fall, they buy put options.

The more nervous they become about the market falling, the more they’ll pay for those put options. And that’s what sends the VIX higher.

However, just because nervous traders are buying put options doesn’t mean the market will always fall.

But it can often become a self-fulfilling prophecy.

That’s because if those same traders are expecting a fall (and are buying put options), they’ll also be selling out of their long positions. That can add to the wider selling momentum – sending the broader market lower.

But even if you don’t trade options at all, the VIX can still be a useful tool for traders.

Watching the Charts

Take a look at the chart below of the S&P 500 overlaid with the VIX…

The blue line represents the S&P 500 Index (SPX), and the red line is the CBOE Volatility Index (VIX).

Let’s look at the relationship between the two…

You can see that each of the spikes in the VIX has coincided with a fall in the index. That applies to both the larger and smaller moves.

Put simply, when the VIX spikes, we can expect the index to fall. For a trader, this type of information can be crucial…

If volatility starts to rise, we may delay going long in a stock (or the index). Or if we’re looking to short a stock (or index), we might use a spike in volatility to help determine when to enter.

However, it’s not only the initial spike in the VIX that traders watch closely…

You’ll notice that these spikes in the VIX are typically only short-lived. They often last no more than a few days. Traders also find what happens after the spike to be helpful.

To see what I mean, let’s take a look at the bull market back in 2021…

While SPX initially fell when the VIX spiked at the start of 2021, it subsequently went on to rally as the VIX dropped back to its normal range.

So instead of using a spike in the VIX as a signal to go short, traders who are bullish on the long-term trend of the market might use a pullback (from a spike in the VIX) as a trigger to go long…

That’s why the VIX can be a useful tool in either market direction.

To be clear, the VIX might not work 100% of the time (nothing does in the markets).

However, it can offer a much broader and deeper understanding of future short-term movements of the market, rather than just relying on fundamental and technical analysis.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict

P.S. If you have any questions you’d like addressed in a future mailbag issue, please send them to [email protected].