Why The CBOE Volatility Index Helps Pinpoint Market Bottoms

Investor's Business Daily

If something is volatile, it has a tendency to evaporate rapidly or, according to the Latin root of the word, to be fleeting, transitory.

In the stock market and politics, the term often describes a situation that is wildly unstable, prone to upheaval or to change quickly.

Most investors prefer a stable climate. Some thrive on market upheaval. In either case, having some sense of when the weather is about to become blustery can be useful.

The Fear Gauge

One of the leading tools in such weather-watching is the Chicago Board Options Exchange's Market Volatility Index, widely known as the VIX.

Introduced in 1993, the VIX currently is based on a wide range of call and put option prices for the S&P 500 large-cap index. Often referred to as the "fear gauge," the index is an indicator of market psychology.

When a market is in free fall, investors dive in and bid up options prices. Such trading has often caused the index to spike just as the market nears a key upturn.

One example: During the sell-off that followed the Sept. 11 terrorist attacks, the VIX spiked to 43.7 in the week ended Sept. 21, 2001 1. That was its highest mark in almost three years.

The S&P 500 turned up the following week, marking a Day 5 follow-through and rallying 25% over the next 3-1/2 months.

The VIX only gestures toward shifts of direction, not necessarily the exact start of rallies. On July 23, 2002, for example, the VIX bolted to 44.9. The market climbed for the next four weeks, then turned sharply lower.

Three months later, the VIX rebounded to 42.6 in the week ended Oct. 11. The Nasdaq bottomed that week. It posted a 5.1% Day 4 follow-through the following week, signaling a new bull market.

Such links have made the index handy as a supplemental tool, often used in concert with other psychological indicators, including the Investors Intelligence Bulls vs. Bears survey and the put-call ratio.

Still, it shouldn't be mistaken as a hard and fast market indicator. Case in point: October 2008, when the VIX spiked to a record high. Both the Nasdaq and the S&P 500 continued to tumble in four of the next five months. The index showed only a moderate uptick before the market actually bottomed and turned higher in March 2009.

None of those stand in for a basic understanding of how markets form bottoms, then launch rallies with follow-throughs. When the VIX stabbed a six-month high of 21.91 on June 24 this year, savvy investors would already have been tuned into the rising Nasdaq and S&P 500 indexes, looking for rally-confirming follow-through action.

To improve your market timing, use the Big Picture column  to track key market turns, both bottoms and tops.

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