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Reading the VIX

Posted on March 17, 2009 by Adam

Lately I have been watching the VIX very carefully. It’s movements have been quite actionable, and even predictable to some extent. Over the last couple of months I have watched the VIX steadily trend higher. Last week, the VIX broke down beneath that trendline, acting as a confirming indicator for the current rally.

If you don’t know, the VIX is an index that measures volatility of options. Basically, when the VIX is high, the market is fearful. When the VIX is low, the market is greedy. Extended bull markets are known for their periods of low volatility - it’s not unusual to see the VIX trading in the 10-20 range. Bear markets instill a lot of fear in the markt, and as a result the VIX trades higher. The height of the panic last year saw the VIX reach about 90!

I look at the VIX heading lower as a very bullish sign for the market. Yesterday the VIX increased, even as the market opened higher, but it stopped right at the critical level of retesting that old trendline. Today it has again reversed lower. This has me believing that stocks want to go higher.

The VIX has broken down beneath it's upward trend, signalling a rally is underway. All the while, it has been making lower highs.

I don’t think we are out of the woods in terms of this bear market - not by a longshot. I think we still have to make one more test of the lows before we can enter a new bull run. Interestingly, the VIX was making lower highs, even as equities were making lower lows. I look at that as a bullish divergance. It signals that even though prices were below the November lows, investors were increasingly confident that the market would form at least an intermediate-term bottom.

I think we will know when the next bull market is in place when the VIX is below 30. By the time we get to that level, it will already have started.