Investor Alert

Dec. 14, 2011, 12:34 p.m. EST

The VIX is not a crystal ball

By Jay Pestrichelli

By the close of Tuesday the VIX ended below its 200 day moving average. Typically crossing below the 200 day moving average for anything indicates a new strength for a downward trend. But does this mean we will finally see the end of volatility?

Over the last few years the VIX (845:VIX)  has earned the moniker as the "fear indicator" for the market. And while it is comfortable to associate something we don't fully understand with one of the emotional pillars that drive the markets (greed being the other), there isn't actually anyone taking a real-time sentiment survey and reporting on fear like Consumer Confidence to create this index.

What the VIX actually tells us is how volatility is reflected in the options market known as implied volatility (IV). IV is one of the pricing components of options and the higher it goes, it tells us the more expensive options have become.

Options are used in many ways, but the two predominant applications are as speculation and protection. So as options get more expensive it gets more expensive for the dice-rollers to speculate and hedgers to protect.

So to close the loop on this fear thing, we can say that as options get more expensive so does the cost of purchasing options. But really it means it gets more expensive to be greedy (speculate) or to be fearful (protect).

When the VIX, that represents volatility of options, starts to drop, it doesn't mean the market is necessarily less fearful. It also means it is less greedy (if there is such a thing). Or said another way, it means that the market has experienced a lower chance of large swings in either direction. Perhaps its easier to think of the VIX as the surprise factor.

If that is the case, is anyone really caught off guard that the VIX is comparatively low right now? The market has been range bound now for the last two months. Despite headlines causing plenty of days with intra-day moves of greater than 1%, a great run in October only to retreat in November; the tops and bottoms are beginning to feel telegraphed for the major indexes.

What the falling VIX does tell us is that the market, particularly the options market, is not surprised by the moves over the last month, and option prices have dropped as a result. And the fact that it has now fallen below the 200 day moving average, tells us that there is less of a chance for a surprise than usual.

Does this mean that the market is going to be dull? Did we all have too much turkey at Thanksgiving and will we find that we've slept through to New Years? Probably not. While the VIX has some impact on the probability models of tomorrow, it is more of a reflection on how we got to where we are now.

If it were predictive in nature for more than a few days it would have done a better job forecasting the volatility in the second half of the year. For example, the VIX was as low as 16 in early July, completely unaware of the tremendous moves that were coming. At that time it was more of a reflection of the markets' perseverance through the Arab Spring and the tsunami in Japan.

So if the VIX doesn't help us predict, what can we use if for? Go back to the root of what the VIX represents, the volatility in the price component of options. That means the VIX can help determine if options are cheap or expensive on a relative basis. And hence if traders plan to speculate or investors plan to hedge, it means that it's cheaper to do now, than it has been on average over the last 200 days

Link to MarketWatch's Slice.