Does a Falling VIX Mean the Worst is Over?

Ron DeLegge
October 11, 2011

Since spiking above 45 on October 3, the VIX has slid hard and fast, retreating to around 33. What is the VIX and does its recent drop mean the worst is over?VIX  BasicsThe VIX is a forward looking tool that measures the expected future volatility of the S&P 500 stock index (NYSEArca: SPY - News) for the next 30 days. The VIX is quoted in percentage points and it was first introduced in a research paper by Professor Robert E. Whaley at Duke University.Today, the VIX indicator has become a popular gauge of investor fear and complacency. A high VIX reading signals fear whereas a low reading means increasing risk appetite among investors. By using a weighted blend of various S&P index options, the VIX attempts to estimate the implied volatility for U.S. stocks. Betting on Volatility - Good idea or Bad?Although there is no way to invest directly in the VIX, trading the VIX can be done with futures contracts or options. The cost of futures or options contracts will be impacted by factors like the expiration date of the contracts and the S&P 500's movements. A surging VIX will undoubtedly result in more expensive contracts, whereas a falling VIX, the opposite.The advantage of trading options or futures is that it allows the trader to choose the expiration date of their bet. The disadvantages are time decay and the wild swings that come with the territory.Financial products that leverage the VIX include the Velocity Shares Daily 2x VIX Medium Term ETN (NYSEArca: TVIZ - News) and the Velocity Shares Daily 2x VIX Short Term ETN (NYSEArca: TVIX - News). For VIX bears, Credit Suisse also has inverse or short versions on the same theme with VIX short term (NYSEArca: XIV - News) and medium term (NYSEArca: ZIV - News). Even though a number of exchange-traded notes or ETNs linked to the VIX have popped up over the past several years, ETFguide has repeatedly warned its subscribers about the imminent danger of these products. If you really want to trade the VIX using an ETF-like vehicle, our weekly ETF Pick from October 6 outlined several alternatives.What is the VIX Saying Right Now? The VIX is arguably one of the best tools for measuring the financial market's mood and sentiment. As of late, movements in the VIX have been reacting to news about Europe's banking (NYSEArca: EUFN - News) and sovereign debt predicament. For now, as Europe goes, so goes the VIX, it could be argued. Yet, while the VIX is typically used to measure fear, we've successfully used it as a contrarian indicator or barometer. Low VIX readings, in fact, are indicative of complacency, which almost always leads to declines that surprise the market. Has the VIX reached a temporary bottom?  The fact that riskier assets have outperformed lower risk assets over the brief rally that began last week tells us that an increased appetite for risk taking by the crowd is taking place. This is evident across multiple investment categories including emerging market stocks (NYSEArca: VWO - News), high yield debt (NYSEArca: JNK - News), and small cap stocks (NYSEArca: IJR - News). Should you join them?In our weekly ETF update to subscribers, here's what we said, 'Unlike 2008, today's problem is a multi-faceted array of global and domestic financial problems which are much larger and more dangerous. Back then, it was too-big to fail financial institutions that threatened global stability. This time around, we still have that same problem plus we've got world governments on the brink. The name of the game right now is to hold defensive assets.'What are the ETFs or 'defensive assets' to be holding? And at what point will the VIX trigger a good setup? The ETF Profit Strategy Newsletter tells you the answer by using the VIX along with technical analysis to identify key inflection points in the market and major investment themes for profitable trades.