Analyzing the VIX

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The VIX (Volatility Index) is a good measure of fear, or lack thereof, in the stock market. It is constructed by measuring the amount of premium on a select group of put and call options. When options writers are more fearful, they charge a higher premium, which translates to high VIX readings. Low VIX readings are evidence of complacency.

A subscriber recently called my attention to a chart from which shows a six-year chart of the VIX compared to the SPX. Below is our version of that chart, highlighting the market action that occurred when the VIX reached current low levels.

VIX five year 24 jan 2013

When I see such reliable repetition, I immediately want to see how the indicator behaves over a longer period. There is, for example, that very low reading on the left side of the chart. What's that about?

Below is a 20-year chart of the VIX and SPX. We can see that there was another period between 2003 and 2007 when the VIX was good at picking price tops upon reaching a level similar to the most recent five years -- about 15. Unfortunately, there were two extended periods (circled) when the VIX carried much lower readings -- about 10 -- and was much less useful in identifying price tops. Another observation is that these periods were associated with bull markets, which probably reflects strong investor confidence at the time.

VIX long term 24 jan 2013

The current VIX reading is lower than any reading since 2007, so we must wonder if the VIX may be descending into another extended period of bull market confidence, characterized by a lower VIX range with a bottom of about 10. We can't rule that out, but we have so many other indicators that are overbought and long-term overhead resistance at about 1550, that my best guess is that the VIX is warning us of an impending price top, not the beginning of a new bull market era.

The main thing to be learned is that indicators can behave one way for an extended period, then change and behave entirely differently. Always try to find a longer-term chart to see if current behavior is typical or subject to change.

Technical analysis is a windsock, not a crystal ball.

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About Carl Swenlin