Technical analysis has many devotees as does Fundamental analysis. These tools try to measure past performance and extrapolate to the future. If you are a “buy and hold” type of investor, these tools are invaluable to help choose a suitable investment. But if you are a trader, a new set of measurements play a really important part of being able to “time the market”, something we mere mortals are told never to try. But the truth is, the “real players” do it all the time. And to the trader there is nothing more important than the current emotional makeup of the market.
It’s the fear and greed thing. If you are fearful, you and other short term traders or panicky long term investors are more apt to sell. If there is confidence in the near term future, buying is much more likely. If you know that fear is building in the general trading population, you can anticipate that there may soon be selling. Likewise if you know that the general perception is for clear skies and smooth sailing, you can feel assured that the general direction of the market will be up- or complacency is setting in and change may be in the wind.
In 1993, a new measurement for the index of volatility for the S&P 500 stock index (SPX) came out with the purpose of measuring fear and greed. It’s called “the VIX”. If the VIX index goes up, it means that traders and investors may be heading for the exits. Conversely, if the VIX goes down, money is coming off the sidelines and moving into equities. Confidence and optimism rule the day. In other words, the VIX is an inverse indicator: when it goes up, the probability of prices going down is increased and vice versa when the VIX moves down. But how does the VIX come to these conclusions?
The VIX is quoted in terms of percentage points and translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period and is based on the activity in the stock options markets. The VIX is traded on the futures exchange and can be traded just like any other investment. Moreover, it can be used to hedge positions. For example, if you see the VIX start to rise, it may be telling you that the level of fear and uncertainty is increasing and you could purchase VIX contracts on the CBOE. If the market does indeed start to sell off and the VIX rises, the profits gained by the VIX futures can help offset some of the losses that you might experience in other investments.
Many people feel that the VIX is the most accurate indicator of sentiment but not only is it a good indicator it can be traded for its own potential or used in a strategy to help protect unrealized gains. For investors who own open ended mutual funds, the VIX can act as a hedging strategy just as a put option strategy is used to hedge long positions in stocks.