Is VIX forecasting a stock market surprise?

The volatility index is near historic lows as complacency runs high. Here are some long and short plays based on its future direction.

By May 24, 2013 12:53PM

Dice on stock listings copyright Kate Kunz, CorbisBy John Nyaradi, Wall Street Sector Selector

In recent days, the VIX or CBOE S&P 500 Volatility Index (VIX) -- also known as the fear index -- has dipped back into extremely low territory, indicating high investor complacency and confidence in the short-term future of low volatility and higher stock market prices. 

Friday's low volatility and readings in the VIX is a result of investors anticipating continued Federal Reserve intervention in the markets. The current situation has driven the index to the 12 to 13 level in recent days, near historic lows.

The VIXis widely viewed as a way to measure market risk (MoneyShow) and forecast future stock price movements. Some observers say that when the VIX is low, market risk is low, and prices are likely to trend higher. This camp also says that when the index is high, lower prices are ahead as fear is the dominating force in the market.

Contrarians say to "sell the greed, buy the fear" and so when the index is low, contrarians would be anticipating declines in stock prices ahead and selling long positions or going short. When it is high, they would be expecting a reversion to the mean and entering long positions.

This correlates to Warren Buffett's famous advice, "be fearful when others are greedy and greedy when others are fearful." Right now, greed is dominating global market places and so perhaps the foxy old Oracle of Omaha would be saying that now is time to be fearful instead of greedy and complacent.

If you're interested in trading the VIX on the long side, a popular choice is iPath S&P 500 Short Term Futures ETN (VXX).

Click to Enlarge

In this chart, we can see how the iPath S&P 500 VIX ETN has declined sharply year-to-date and is now well below its 50-day and 200-day moving averages and bouncing along at recent lows. 

Although this is a high volume, popular ETN, it has significant tracking error problems and suffers from what’s known as "contango," wherein prices of the underlying futures contract go steadily higher over time. So the ETN will constantly lose money unless volatility takes a sharp spike. This ETN is suitable for short-term holding periods only.

On the "short" side of VIX is Velocity Shares Daily Inverse VIX Short-Term ETN (XIV). This ETN is designed to inversely track the volatility in the markets as measured by the S&P 500 VIX Short-Term Futures Index. 

It is designed to rise in price as the VIX declines and does not have as much tracking error as seen in other VIX products. Nevertheless, it, too, is subject to wild swings in price and will typically gain in value as the S&P 500 gains in value and volatility declines.

Click to Enlarge

In this chart of XIV, we can see how it has gained more than 30% since the start of 2013 but has also had two bouts of steep declines in the neighborhood of 20%.

VIX currently continues to plumb low levels as investors anticipate further central bank support in spite of recent dialogue from various Fed members that the Fed should start cutting back on its quantitative easing programs. Fiscal policy from the sequestration will also serve to be a drag on the economy, along with the recession in Europe. 

Global central bank action will continue to set the tone for the stock market going into summer as monetary intervention works to offset a slowing global economy.

Bottom line: Low VIX generally means higher equity prices and vice versa, and so investors and traders will be paying close attention to all of these events. Markets are overstretched and overbought and so a spike in volatility would not be a surprise, particularly since no one is expecting such a move. So, indeed, VIX could be forecasting a stock market surprise.

More from The MoneyShow

May 24, 2013 1:05PM
So what seems to be happening, the richer those at the top get, the more confident those in the Middle and at the bottom are that it will Trickle Down to them? Well it hasn't happened for well over a decade and I don't expect it to happen, anytime soon. If consumers are really 70 percent of the economy, then the neglect shown to them by Corporate America will eventually have a very long term negative effect on stocks and the economy.  Until then, the big BANKS and Uncle Ben are enjoying  the Best of Both Worlds. They get to Rob you blind, and then blame someone else.
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