Randy Frederick

   

Many option traders believe that the CBOE Volatility Index (VIX) can help predict bullish or bearish market sentiment. The VIX is calculated using the implied volatilities of put and call options that are currently trading on the S&P 500 Index (SPX).

In fact, some people view the VIX as a measure of fear in the market. If the old saying that "the market is driven by two things: fear and greed" is true, then having a way to measure one of these items could be beneficial.

However, in recent years the VIX has arguably become less effective. Put/call ratios, another market-sentiment statistic, may be a potential alternative. We'll discuss the pros and cons of each of these ways to track volatility.

There's No Crystal Ball

I think there's little doubt the VIX reacts to the market: It seems to nearly always draw a perfect mirror image of the movement of the SPX. However, it rarely -- if ever -- predicts the SPX. I have charted and studied the VIX for many years and while there are short periods of time when it does seem to lead the market, I haven't seen the VIX forecast the future with any consistency.

While the idea of a "fear gauge" may seem appealing, it's more accurate to think of the VIX as a possible measure of market uncertainty. In the market, uncertainty about the future is often described as "implied volatility." Simply put, the more uncertain the market is about the future, the higher the implied volatility; the less uncertain, the lower.

Unfortunately, volatility is non-directional, so while the VIX may be able to predict some kind of market movement, it can't possibly predict the direction in which the market may move.

The VIX Has Been Less Effective In Recent Years

Back in the late 1990s, subscribers to the VIX theory believed that levels above 30 (the green line in the chart below) were bullish, while levels below 20 (red line) were bearish. Because the VIX was considered a contrarian indicator, the thought was basically that rising or high volatilities were considered bullish, while declining or low volatilities were considered bearish.

Bryan Perry

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