The Fear Indicator Every Trader Should Watch

08/05/2010 12:01 am EST


The VIX, or CBOE Volatility Index, also known as the fear indicator, uses the implied volatility of S&P 500 index options and is an index of the market’s forward-looking view of volatility for the next 30 days.

This indicator is widely viewed as a way to measure market risk and forecast future movements. Some observers say that when the VIX is low, as it is now, that market risk is low and stock prices are likely to trend higher. This camp also says that when the VIX is high, lower stock prices are ahead because fear is the dominating force in the market.

On the other hand, contrarians say to “Sell the greed, buy the fear,” and so when the VIX is low, contrarians would be anticipating declines in prices ahead, and when it’s high, they would be expecting a reversion to the mean and lower prices ahead.

If you’re interested in trading the VIX, iPath offers an ETN that tracks this index.

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Its symbol is VXX, and from the chart above, you can see that it’s widely traded and has been in a downtrend since early summer except for the pop that occurred in late June during that recent short correction.

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And here’s a chart of the VIX itself, with a 50- and 200-day simple moving average superimposed over it.

You can see how prices have been declining since early July, but are now firming right at the 200-day moving average, and MACD is flattening out and apparently trying to make a turn higher. Advocates of low VIX/higher prices scenario would say that stock prices should now rise because the VIX is low, while contrarians will say that with a low VIX and price above the 200-day moving average and starting to climb, there’s now a good chance of lower stock prices ahead.

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Until just a couple of weeks ago, the only option for trading the VIX via exchange traded notes was the VXX on the long side, however, Barclay’s has just introduced an ETN that moves inversely to the VIX and allows you to “short” the VIX if you think it’s headed lower.

Trading under the symbol XXV, you can see in the chart above that it started trading in late July and already is putting up impressive volume numbers. It’s not a risky forecast to say that this ETN will quickly become very popular and widely traded as investors and traders expand their participation on both sides of this interesting market.

So in a nutshell, if you think that volatility is increasing, you would be a buyer of VXX, and if you think that volatility is heading down, then XXV would be a possibility for your portfolio. I have had good success trading VXX, but would caution that you must approach trading volatility with a professional plan because volatility is, well, volatile, as you can see from the charts above. Now with the advent of XXV, I’m also looking forward to taking advantage of potential opportunities on the short side of the volatility market.

There is a lot of research available on the VIX, and if you’re interested in trading this vehicle, you’ll have lots of company now that there are two simple ways to do it with exchange traded notes from iPath and Barclays.

By John Nyaradi of
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