More Volatility Ahead? - John Rothe | Portfolio Manager, Quant, Tech Geek, And Sometime Superhero To My Kids

More Volatility Ahead?

The protests in Egypt caused the VIX to spike last week. This may be a continuing pattern as investors gauge market risk. The VIX is a measurement of investors expectation of how volatile the markets may be over the next 30 days. It is constructed using the implied volatility of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk and is often referred to as the “investor fear gauge”.

Investopedia explains VIX – CBOE Volatility Index
The first VIX, introduced by the CBOE in 1993, was a weighted measure of the implied volatility of eight S&P 100 at-the-money put and call options. Ten years later, it expanded to use options based on a broader index, the S&P 500, which allows for a more accurate view of investors’ expectations on future market volatility. VIX values greater than 30 are generally associated with a large amount of volatility as a result of investor fear or uncertainty, while values below 20 generally correspond to less stressful, even complacent, times in the markets.

The daily chart of the VIX shows a one day breakout, something that has happened in the past as a knee jerk reaction to various news stories:

However the MACD has been rising since late December and may give us a better indication of what lies ahead. The chart above shows a divergence, which refers to a discrepancy between the MACD line and the graph of the stock price. Positive divergence between the MACD and price occurs when price hits a new low, but the MACD doesn’t. This is interpreted as bullish, suggesting the downtrend may be nearly over.

If we take a look at the weekly chart of the VIX, we can also see the VIX has a tendency to rebound from these low levels:

So what does a rise in the VIX mean for the market? Since the VIX is based on options trading of the S&P 500 index, the VIX gives us a good indication of what large investors and institutions are doing with their portfolios. If more investors are buying calls, they’re betting that stocks will rise. As a result, the VIX will head lower amid perceived complacency. If there’s more put option-buying, it’s a sign that investors expect stocks to fall. This fear will cause the VIX to rise.

For now, keep an eye on the VIX. If the levels start to rise dramatically and the current trend of the market changes, we may start raising cash in our portfolios.

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