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Volatility Index "VIX" – The “Fear" Index
The VIX represents the market volatility index. Its value indicates the estimated volatility, upward or downward, for the S&P-500 index from the present time to a period of one year. Mainly, the VIX is used to calculate the amount of premium the S&P-500 Option traders have to take into account for pricing the S&P-500 Call and Put options. For example, a value of 20 for the VIX means that, according to the current market conditions, the S&P-500 should go either up or down 20% of its current price with a probability of one standard deviation (67 percent) within a one-year period,
The time premium for the S&P-500 Options is for the next 30 days. The 20 percent being for one year, the rate for the next 30-days or one month, is calculated with the formula 20 divided by root square of 12 . This becomes a 5.7735 percent premium for each moving 30-day period.
Although the value of VIX indicates a neutral price fluctuation upward or downward, it is called the Fear Index because the market does not like high volatility. In general, the markets tend to go down when the VIX goes up. The VIX is a leading indicator of investor sentiment and the crowd's psychology.
Why do we want to understand the VIX? This is because it is a Leading indicator. It tries to forecast the future trends, like the MPS. Actually, the instantaneous trend for many market indexes such as the S&P-500, the Dow Jones Industrial Average, the NASDAQ composite and the NASDAQ-100 are driven by VIX. This is why it is included in the Trend-Prediction Strategy.
The emotions of fear and greed drive heavily the financial markets. This is why traders cannot be successful in the long run, if unable to manage their psyche and mental states. The VIX measures the state of the market and crowd psychology. It is a measure of fear and stress as perceived by the market participants.
It was said earlier that although the TSV and the MS follow quite closely the market real-time trends, they still lag the markets slightly. This is the reason why the VIX was introduced as a component of Trend-Prediction Strategy.
How does the market choose to take a certain trend? Well, basically, the S&P-500 option trader's mental state and psychology interprets the events in one direction by some and in the opposite direction, by others. This then triggers actions to buy and sell the S&P-500 Call and Put options. In turn, this provokes fluctuations of the VIX value, which is computed based on the ratio of Call and Put Options. Once the VIX fluctuates, the stock market indexes and individual stocks use it as input to adapt to the newly modified market’s conditions.
The markets do not like volatility. This is why they go down when the VIX goes up and vice versa. In other words, the VIX and the market indexes and stocks, tend to move in the opposite directions of each other.
Above describes the theory necessary to understand the VIX Index. Let us now get practical and see how we can apply this knowledge to predict the market trends. In TC2000, the VIX is called “VIX--X”.
Figure 4.39 Charts courtesy of TC2000.com
Figure 4.39 shows a monthly chart of the VIX from 1986. The gray line comparison index is the yield of the Treasury Five-Year Notes. Why the market goes down when the VIX goes up and vice versa? We know that when the VIX is high, it signals a higher implied interest rate. Higher interest rate increases the maintenance costs of the borrowed money by the companies and therefore, may shrink their bottom line substantially. Furthermore, higher interest rates may have an adverse impact on the global economy and employment rates. Let us assume that the VIX is high. This implicitly indicates higher interest rates and sluggish markets, recession or depression. Under such circumstances, the politicians and the central bankers fear higher unemployment rates, which could not only undermine the government’s tax income but may also make the politicians unpopular and cause adverse effects for their carrier and political parties. As a result, they intervene, for example, by lowering the interest rate. In doing so, they lower the cost of borrowing, combined with the easier access to money for professionals and private consumers. This intervention is supposed to generate additional demand, improve the state of economy, and to lower the unemployment rates. Conversely, when the VIX is down, something that implies lower interest rates and improving economic growth, the interest rates could go higher due to stronger demand for money but without significant negative impact on the employment rates.
We can apply the TC2000 indicators also to VIX. Currently, a few constraints are associated with the VIX data feed of TC2000. First, data is available for the VIX Index only during the US market opening hours. Therefore, we cannot use the VIX as a leading indicator outside of the US opening hours. Second, all necessary end-of-day data is available for the VIX daily and longer-term charts. However, the real-time volume data for VIX is, unfortunately, unavailable. Consequently, the real-time intra-day TSV indicator is unavailable for the VIX. Luckily, the real-time data is available for the Money Stream, which we are going to use to predict the market trends.
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