by Guest Author Doug Short, cross posted from advisorperspectives.com/dshort
The first chart features an overlay of the S&P 500 index and the CBOE Volatility Index (VIX) since 2007. Yesterday the VIX rose to 48.00, a gain of 50% over the previous close.
As the chart above illustrates, the correlation between the S&P 500 and the VIX is inverse but imperfectly so. The lower low in the summer of 2008, when the index nearly dipped to 1200, came with a lower VIX in the upper 20s. More significantly, the unprecedented surges in the VIX above 80 in late 2008 predated the actual index low by over three months.
A key to understanding the VIX is to realize that it can be far more volatile than the index to which it is attached. The next chart inverts the VIX values, which helps us see more clearly the greater degree volatility and the fact that the VIX tends to lead the S&P 500.
The spike in the VIX of late is a bit worrisome, especially because it has exceeded 30 level associated with high volatility. See also the markers at the bottom of both charts, which identify days on which the VIX spiked by more than 30%, something that's happened four times since the March 2009 low. In particular, we can see the increase in volatility associated with the 16% correction that began in April 2010 and ended in early July. The immediate question is whether the spike in volatility during the past few days, which included two 30% plus spikes, is a leading indicator of additional market decline.
For a look at the VIX and S&P 500 since 1990, click here for some additional illustrations.
Note 1: I've updated these chart through the Wednesday close, with the VIX at 42.99, a 22.6% increase from Tuesday's close.
Note 2: For anyone needing a VIX refresher, Investopedia provides a handy overview:
VIX: The ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk and is often referred to as the "investor fear gauge".... VIX values greater than 30 are generally associated with a large amount of volatility as a result of investor fear or uncertainty, while values below 20 generally correspond to less stressful, even complacent, times in the markets.
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