What is "The Vix"

Adrian was curious so I wrote an entry on it.
What is the VIX?

"VIX is the ticker symbol for the Chicago Board Options Exchange Volatility Index, a popular measure of the implied volatility of S&P 500 index options. Referred to by some as the fear index, it represents one measure of the market's expectation of volatility over the next 30 day period." Thank you wikipedia.

I am one of those who refer to it as the "fear index." Simply put, the higher the VIX (the more volatility) the more fear is out there. So why is the VIX useful to us? It is a good predictor of market bottoms. A typical VIX reading is somewhere between 10 and 30. A VIX reading of 30 or higher denotes a significant amount of fear out in the market. Some interesting things to note. The absolute bottom of the 2000-2002 bear market had a VIX reading of 50. Short term corrections during the bull market from 2002-2007 had VIX readings in the high/mid 30's. The VIX briefly touched 37 during the recent January 22nd, 2008 bottom. In the market crash of 1987, the VIX hit a reading of above 100.

So when the VIX jumps up, why is that likely signalling a bottom? Basically, if there is a lot of fear, it means people are panic selling. All these "weak holders" are chased out of their stocks and once they all sell prices will no longer continue to be pushed down and can start going up again. Another way of saying panic selling is capitulation. Until the market under goes capitulation, we cannot hit a true bottom because many stock holders are eager to get out and every time prices come up a little bit, they will sell and knock the prices back down. When the VIX hits 50+ all those people who were looking to sell on any bounce will have unloaded all of their stocks out of fear of lower prices, so stocks can finally begin going up again.

Why do I think this is not the "true" bottom for the stock market? A number of reasons.

1. The VIX only hit 37. While that is a high reading, we have had a 5 year bull market and there has been a lot of speculative excess, just look at the turmoil in the credit markets. The idea that a 5 year bull market can just take a 3 month breather, hit bottom and resume its run is a little far fetched. The average bull market lasts 3 years and the average bear lasts 1 year.

2. TV commentators (most notably Cramer) are calling this the "bottom."

3. When stocks have been selling off, its on big volume, when stocks go up its on light volume. That is not the sign of a healthy, bull market. Its the sign of a bear market. Every attempted rally since the Jan 22nd low has been sold off into on higher volume than the rally.

4. Investors Intelligence Survey did not have a "cross"(a cross is when more people surveyed report being bears instead of being bulls), bulls still outnumber bears.

5. Put/Call Ratio, similar to the VIX, when it reads over 2.0 it tends to mark bottoms. The reading was not close to this.

6. Friends of mine are buying Apple. Nothing screams "This is not a bottom" when you have amateurs buying up former market leaders at "bargain" prices.

7. The short interest is DECREASING.(short interest is the number of shares sold short ie. people who sell shares short are betting that prices will decline further. If there are fewer shares sold short it means people are taking those bets off the table.) I find this very interesting. Basically, in the last couple weeks the numbers of shares that have been sold short has dropped. This means shorts have been BUYING BACK their shares. Now is this a bullish or bearish sign? An absolutely bearish sign. All these low volume rallies have probably been due to shorts buying back their shares and all the high volume sell offs have been due to people dumping their positions. Guess what happens when all the shorts who wanted to buy back their shares have done so.

8. At market bottoms you tend to have huge short interest. These short sellers help fuel the rally off the lows because they are forced to buy back their shares due to fear of losses. Like I just mentioned, this is not the case.

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