VIX FEAR PREMIUM

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APPLICABLE TIME FRAME(S):  

SHORT / INTERMEDIATE

UPDATE SCHEDULE:

Each weekday night by 7:00 PM EST

EXPLANATION:

The VIX measures the implied volatility (i.e. estimated future volatility) of near-term at-the-money SPX options (click here for an excellent overview of options by the CBOE). 

If the SPX moves significantly, new strike prices are used to calculate the VIX.  Since there is a skew to options prices and implied volatility changes with the strikes, the VIX will typically rise when the SPX drops and fall when the market rises.  This is not always the case, but the correlation is clear.  The common interpretation of VIX movements is that the VIX will rise when fear or uncertainty does, since there will be a greater demand for put options.  Conversely, when the market is rising, that typically creates complacency on the part of traders and the VIX will fall as the demand for put options decreases.

Since the VIX can go through periods of being elevated and periods of being depressed, it helps to think of it in terms of actual volatility.  If the VIX is high during periods of high volatility, perhaps it is simply reflecting the times we are in and not necessarily fear or uncertainty, which is the common interpretation of this indicator. 

The VIX Fear Premium is a proprietary indicator that measures the extra volatility that is currently being built into the VIX.  This premium is the amount by which the VIX is above or below recent historical volatility.  For example, if actual volatility is low but the VIX (implied, or "future" volatility) is rather high, then there is a good amount of fear or apprehension currently in the market.  This often corresponds to market low points.  Conversely, if actual volatility is high but the VIX is relatively low, then there may be too much complacency in the market and that usually leads to a market decline.

GUIDELINES:

Determining "high" and "low" levels is the key to the puzzle, and we have applied standard deviations to the chart to help us interpret current levels.  The bands are 1 and 2 standard deviations from the recent mean.  When the fear premium approaches or exceeds the upper bands, we can conclude that there is significant fear being built into the VIX and a low may be near.  Conversely, if the fear premium declines close to or below the red (lower) bands, then complacency is excessive and it may be difficult for the market to make much headway until the condition subsides.

The following chart details two examples of the use of this indicator.

Entering the Spring of 2001, the market had been chopping lower and was finally beginning to see some heavy, persistent selling.  Eventually, that selling created a large amount of fear among options traders, as the VIX began to rise significantly over its historical volatility.  This caused the VIX Fear Premium to exceed its upper trading band, which told us that there was a very high amount of uncertainty currently being priced into the market.  Not surprisingly, this fear caused a final panic-type low to form, which in turn lead to an excellent buying opportunity. 

After a few weeks of seeing this rally unfold, traders became more confident that the recent volatility would subside and we may enjoy some solid gains from the long side.  This type of complacency lead to another thrust higher as the late buyers came in, and of course that resulted in the highest prices we would see for quite some time.  The complacency evident in this indicator told us to watch out and use further gains as selling - not buying - opportunities.

Although this is a real example and points out the value of following this information, we do not mean to intimate that the market ALWAYS peaks when there is a high VIX Fear Premium reading, or troughs immediately after the indicator touches its lower trading band.  It is a guideline and not a trading system unto itself.

STATS:

*Standard Deviation.  See below...

68% of readings (1 standard deviation) should be between 1.2 and 10.4

95% of readings (2 standard deviations) should be between -3.4 and 15.0

99% of readings (3 standard deviations) should be between -8.0 and 19.6

In other words, we should expect a reading under -3.4 or over 15.0 approximately 13 times per year.  Since such a reading would be relatively unusual, it suggests that we may be seeing an unsustainable trend.  These figures assume a normal distribution curve.

ADDITIONAL RESOURCES:

Chicago Board Options Exchange (www.cboe.com)

© 2005  Sundial Capital Research, Inc.  All Rights Reserved.