The stock market has swings in its pricing. Some of these swings can be quite volatile. It is hard for an investor to watch their investments go up and down. They are euphoric when it goes up and they are patting themselves on the back for being so smart. They are depressed when it goes down and they think they should get out of the stock market before they lose more money. What can we do to measure volatility in the stock market and what does it tell us?

There was an episode on Seinfeld where Jerry and George got a hot stock tip and they purchased stock in a company. The stock price went down a lot and Jerry decided to cut his losses. George decided to ride it out and when the stock price turned around, he was happy that he had stayed with it. Jerry, of course was depressed all over again. He had not only lost a lot of money, but he felt he had actually lost more because of the potential gain he had walked away from.

Any one who has invested for any length of time has a story similar to the one portrayed on Seinfeld. We have all walked away from a winner just to have that stock turn around. What we need to do as investors is to watch the signs and know when it is time to dump and when it is time to stay. The problem is, what coach should we be looking at to get our signs?

One coach that has been developed is the VIX Indicator. The VIX indicator was developed in 1993 and finessed in 2003. It was developed to be a gauge of the market sentiment. A definition of VIX from the Chicago Board of Options Exchange which developed the index states:

“VIX continues to provide a minute-by-minute snapshot of expected stock market volatility over the next 30 calendar days. This volatility is still calculated in real-time from stock index option prices and is continuously disseminated throughout each trading day.”

The VIX measures the amount of volatility in option premiums. Options are a good indicator of what investors think will happen to the stock market. This is due to their leverage investment effect. The VIX is constructed from the weighted average of implied volatility of “at the money” and “in the money” options on the S&P 500 index. This number measures the anticipated percentage movement in the S&P 500 for the next thirty days.

Those who use the VIX indicate that it can inform the investor of when market swings are coming. It is like the baseball coach giving a signal to the runner to come home or to stay on base. The theory is that like the coach, the VIX can tell you things that you would not otherwise know.

Contrarians in the investment world indicate that when the VIX is low, meaning that investment sentiment is satisfied and passive, it is time to sell. They indicate that when the VIX is high meaning the investor sentiment is worried and scared, it is time to buy. The sentiment here is that you should be buying when others are selling and selling when others are buying.

The problem is that the VIX can give false signals. It will sometimes have a certain amount of volatility that is very short-term. Unless you are a day trader, you would miss the opportunities provided when the market suddenly turns upward. There are so few absolutely good days in the stock market, that you need to be invested when they happen. If you are on the sidelines, you will be like Jerry and not like George.

You can see from the graph that the VIX hit the high in October, 2008 but the S&P 500 did not hit its low until March, 2009. If you are on the sidelines, it would be difficult to determine when to come back into the market solely based on the VIX indicator. It had gone down quite a bit before the S&P 500 reached its bottom and started going upward. The massive spike upward in May, 2009 may be an indicator that you should head to the sidelines, but you do not really know for sure.

Still the VIX is one of the coaches sending you signals on what you should do with your investments. The thing is, you should look at other coaches also before finalizing your decision.

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In 1993 the Chicago Board Options Exchange created a volatility index that it called VIX. They modified this index in 2003 and it has supposedly since been an indicator of market sentiment. The index uses the amount of puts and calls (options) to indicate what the investors’ sentiment is for 30 days out. It will not measure a particular stock or market sector since it looks at all calls and puts for the S&P 500. A low VIX in the area of 20 – 25 should indicate that investors have become uninterested in the market. If the market becomes fearful, the higher the VIX will move. It will decrease as the investor feels confident about its future direction.

Contrarians will use the VIX as an indicator of when they think the market will move in one direction or another. Some feel that a VIX below 20 is a sign of a bear market. Some contrarians will then view a VIX above 30 as bullish.

The non-contrarians view the VIX as just the opposite. They feel that a move above 30 is a sign of more volatility while a move downward indicates that investors are comfortable with the direction of the market.

Below is a chart showing the VIX for the past year with a comparison to the S&P 500 and the 50 day EMA line.

The blue line is the VIX indicator while the red line is the S&P 500 and the green line is the 50 day average.

In an article dated March 16, 2010, Whitney Kisling writing for Bloomberg stated that in a study completed by Birinyi Associates the analysts did not find in their studies that the VIX indicator was able to predict the market movement. “The VIX is a coincidental indicator with limited predictive value” according to the study by Laszio Birnyi and Kevin Plienes.

After the VIX climbed to a record high of 80.86 on Nov. 20, 2008, the S&P 500 advanced 11 percent through April 2, 2009, according to data compiled by Bloomberg. The VIX sank to a 13- year low of 9.89 on Jan. 24, 2007, and the S&P 500 then rose 6.9 percent through June 4, 2007.
Birinyi analyzed the VIX’s performance since September 2003, including six periods of what he called “extreme” volatility, including the November 2008 record. He analyzed 12 times when the VIX fell 20 percent below its 50-day average and 18 periods when it was 20 percent above since 2003. The following is a table of the S&P 500’s average gain or loss during subsequent periods:
You can see from the chart above that since October, 2009 the VIX has spiked above the 50 day average four times. The market did do a slight downturn but the trend line continues to move upward.

However as you can see from the chart without the comparison, the period of time from November, 2009 to present is below 20. So even though it had spikes upward, the overall indicator was still below 20 which would indicate a satisfied outlook. Certainly the VIX indicator is one more avenue to use in your attempts to predict what the market is going to do.