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The Volatility Index (VIX) is derived by calculating how relatively cheap or expensive the index options are on the SPX. When options players are pricing options for low expected forward volatility, these options get cheap and the VIX sinks. When options players are pricing options for high expected forward volatility, these options get expensive and the VIX rises.
The VIX is what is called a "contrarian" indicator. When the VIX is low, the market tends to be near a top, and when the VIX is high, the market tends to be near a bottom.
A subscriber wrote to us that he was skeptical of the importance of the VIX. He suggested that we were making a great "leap in deduction" concluding that the market was wrong when it had climaxes in the VIX. He didn’t think we had a good rationale for our conclusion that climaxes in the VIX "meant" market bottoms.
This was our reply.
We are not making a "leap in deduction." Deduction involves drawing a conclusion about particulars that follow necessarily from general or universal premises. Forgive our picking nits on this one, but we like to be clear about the differences between what's deduced and what's inferred, for reasons that should be clear in a minute. And, we haven’t made an inference here. It's really just an observation.
Here is a chart that shows (only anecdotally, but pretty convincingly) the strong association between a high level on the VIX and important market bottoms.
There tends to be a strong inverse correlation between the VIX and the stock market. Depending on the time frame over which you parse the data, that correlation is in the area of -0.75 to -0.85. That is an extremely strong inverse correlation. In fact, it's about as strong as any correlation you'll find between Price and any other secondary measurement.
AFTER, and only AFTER, observing a strong pattern of inverse correlation, we have made some inferences about why this association might exist. This inference is more along the lines of speculative science, or maybe just pure speculation. But, it has become generally accepted among Stock Chartists.
The theory is along these lines:
Look at a stock chart upside down. It doesn’t look just the "opposite" of one that's right side up. We're used to looking at them right side up, but when you turn them over and view them upside down, you see how sharp the tops look, and how rounded the bottoms. When you go right-side up again, it makes you aware that the bottoms are often much sharper events than the tops. Why? Because, ordinarily, the short interest on a stock is much, much smaller than the long interest, which is to say that most of the shares outstanding are held long. Heck, the most that could be held short would be 50%, if you think about it. Since the company issues the shares in the first place… someone has to buy them. And the only way to short a stock is to borrow it and sell it when you don’t own it. But, somebody owns it (from whom you're borrowing it). So, for every short share, there must be a long share (at least)… though that's not the case in reverse. Generally, there are less than 1-1/2 days' volume worth of short shares out there.
For example, if QCOM averages 20 million shares per day volume, it would be unusual for there to be more than 30 million short shares outstanding. But, there are close to 800 million shares issued. So, 800/30 is almost a 27/1 ratio.
(One caveat to the above. The real calculation might be considered to involve only the "float" on the stock, which is the number of shares available to be loaned, and is very close to the number of shares that are margin able accounts. So, while the math we're doing isn't exactly accurate, it gives the correct idea for our purposes.)
OK. So what does that have to do with anything?
While GREED is a compelling emotion, FEAR is even more compelling. Generally speaking, more anxiety is created by fear of actual loss than by fear of lost opportunity. Now, combine these last two… there are 27 times as many shares likely to get scared when the market drops as will get scared when it zooms. So, when the market tanks there are 27 guys trying to save their butts, compared to one guy who's getting greedy. And when it zooms up, there's one scared guy covering his short and 27 who are getting greedy.
Now who's going to buy an option at ANY PRICE (just get me some insurance, darn it, before I lose my butt)? A scared guy. A greedy guy is going to be more circumspect about what he's willing to pay. And how about a guy who's sitting on a big gain near a market top? He's feeling great. He's not going to pay up for a put… heck, the market is in great shape. He might buy some if they're cheap, but he's feeling smart… he's not going to let the market makers rip him off by paying up for a put. And that defines complacency… and LOW prices on options. And, he's not going to buy calls that are "dear" (high-priced) either, because he knows the market has run way up already.
Now what does the VIX measure? It measures how expensive options are. When will they get expensive? Whenever market makers can sell them for a very dear price. When will that happen? When the buyers are willing to pay up for them. When will that be? When they're scared and looking to save their butts. When will that be? 27/1 odds says it'll be when the market has already tanked hard, when fear is at a maximum, and finally when everyone is in the midst of racing for the exits. Once they’ve all gotten out, or paid way up for the puts, then everyone's out who's gonna get out… and the selling pressure abates, because there are no more shares for sale. And when that happens, that's the bottom. There's no one else selling. The fear has climaxed, and the last of the bulls has capitulated.
Mainly that's human nature when we're in large groups. It doesn’t have to be that way, but it just seems to be the case that it is that way. That's observation with a dash of inference. Not perfect knowledge. It just appears to be the case much more often than not.
Of course, all of this thinking is predicated on the notion that the public mainly buys options and the specialists mainly sell (and hedge) them. The public can sell them, sure, but it's probably true, more often than not, that the specialists are selling the options and hedging, while the public is speculating or hedging positions that they have long in stock.
So there's our inductive thinking on the subject. We didn’t make this up. It's pretty much the mainstream thought among technicians and market specialists. I think it was probably discovered by the observation of the association between maximal fear and market bottoms, and not prescribed by any theory a priori (before the fact). But, I bet floor traders knew it first intuitively, just the way all predatory animals know stuff.
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