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Many market analysts refer to the CBOE Volatility (VIX) Index as a “fear index” because it rises when the stock market declines. The faster the decline is, the higher the VIX often surges. Using rising anxiety as an explanation for the VIX’s rise, however, is only part of the story.
The VIX is best compared to insurance policies we take on our homes, cars and life. Premiums rise when insurance claims move higher. Think about a beach home in Florida after a powerful hurricane. Homeowners will pay through the nose if they can find a company willing to provide insurance after a devastating storm.
The VIX is a compilation of the implied volatility of put and call options on S&P 500 stocks. Market corrections increase the demand for options, which are price insurance. Therefore, the only factor that pushes the VIX index higher or lower is the primary determinate of options prices — implied volatility.
Implied and historical volatility are very different metrics
- Historical volatility measures the past price variance of asset prices.
- Implied volatility tells us the market’s future forecast for price variance.
- Implied volatility is the critical input for put and call options prices.
Bull market conditions pushed the VIX base level to 10
- From 2018 through early 2020, the base level for the VIX was at the 10 level as the stock market took the stairs higher, causing volatility to decline.
- After a spike in the VIX to over 85 in March 2020, it returned to a higher base price at the 15 level.
- The stock market tends to take stairs higher while riding an elevator to the downside, impacting the VIX.
The base has risen to 20 because of changing conditions
- In 2021, the stock market rose, and the VIX moved in a 15-20 range.
- In 2022 so far, the base level has moved higher to the 20 level with spikes to nearly the 39 level.
- The VIX has been making higher lows in 2022, as inflation, rising interest rates and the war in Europe increase the demand for price insurance, i.e., put and call options.
The base could move higher over the coming months
- Higher lows suggest a rising base price for the VIX over the coming months.
- The post-late February support level stands at 18.45, with resistance at 38.93.
- The macroeconomic and geopolitical landscapes support higher volatility levels and a rising base level for the VIX.
The VIX is a valuable tool as it is a real-time indicator of the market’s sentiment
- The VIX is not a fear index; rather, it measures the implied volatility of S&P 500 stocks.
- Options demand rises when market volatility increases.
- Uncertainty in markets increases the utility of tools and metrics that highlight the sentiment.
- Remember that there are no guarantees. A rising VIX does not guarantee a falling market, nor does a falling VIX make a rally a certainty.
- Following the VIX alerts market participants to the shifts in market sentiment that can signal significant price action.
- The VIX was at the 29.43 level on May 20, in the middle of the 2022 trading range.
Thanks for reading, and stay tuned for the next edition of the Tradier Rundown!
Equities News Contributor: Tradier Inc.
Source: Equities News