The VIX index measures the implied volatility of S&P 500 put and call options. The VIX reached an 85.47 high in 2020 as the global pandemic gripped the stock market, causing it to plunge. The index has made lower highs since the 2020 peak as stocks have been on an almost one-way bullish path.
The current VIX level, below 12.50, implies stocks will continue to rally. However, the most significant downdrafts in stocks tend to occur when the market least expects a correction.
What is implied volatility?
The primary determinant of put and call option values is implied volatility, or the price variance that market sentiment determines will prevail over a coming period. Historical volatility reflects the past price variance, while implied volatility reflects future perception.
The VIX index measures the implied volatility of the five hundred S&P 500 stocks. Since the S&P 500 is the most diversified U.S. stock market index, the VIX is a leading future stock market volatility indicator.
Why does the VIX rally in down markets?
Put and call options are price insurance. A long call option insures against rising prices, while a long put option reflects on falling prices.
Since most investors are long U.S. equities in long-term savings and investment accounts, the demand for price insurance tends to rise when fear of a correction rises or when the stock market corrects or plunges. Therefore, the VIX index rises when the stock market falls.
The twenty-year chart shows the VIX spikes higher, to 89.53 in 2008 during the global financial crisis, and to 85.47 in 2020 when the global pandemic gripped markets across all asset classes, including stocks.
The VIX moves higher when market participants seek downside insurance against further declines.
The VIX tells us the Fed will cut rates
In June 2024, at below the 12.50 level, the VIX remains at a low historical level, considering the twenty-year range from 8.56 to 89.53.
Stock prices tend to rise when interest rates are low and fall when rates increase because of the demand for insurance. The U.S. Federal Reserve began raising the short-term Fed Funds Rate in March 2022 from zero to 5.375%. Additionally, the central bank rolled out its quantitative tightening program, reducing its swollen balance sheet and putting upward pressure on rates further on the yield curve. Since March 2022, the VIX has traded in a 11.52 to 37.72. At under 12.50, the VIX is near the low, indicating the market believes the central bank will begin reducing interest rates, causing bonds to rally sooner instead of later. The current VIX level is sign that market sentiment believes rates have reached a top and will decline, causing stocks to reach higher highs. Meanwhile, the latest record high in the S&P 500 on June 12 was near 5,450, justifying the low VIX level.
Geopolitical and U.S. domestic political issues could make the VIX inexpensive
Markets reflect the economic and geopolitical landscapes. In the U.S., while inflation has declined, the economic condition remains stubbornly above the Fed’s 2% target, weighing on the potential for rate cuts. The U.S. political landscape is a mess, with the 2024 election on the horizon. The incumbent President faces historically low approval rating, and his challenger, the former President, faces a slew of felony charges and a recent conviction on 34 charges in a New York court.
The wars in Ukraine and the Middle East threaten world peace. The bifurcation of the world’s nuclear powers has complicated relations Meanwhile, sanctions on Russia and China have caused BRICS countries to move towards a BRICS currency with gold backing to challenge the U.S. dollar’s role as the global reserve currency.
These issues and any surprises could cause sudden violent stock market action, causing the VIX to explode higher from under the 12.50 level.
A short-term trading tool that requires time and price stops
The VIX or related VIX products that move higher and lower with the volatility index can be valuable tools that manage stock market risk. With the volatility at a low historical level, this could be a perfect time to put the VIX on your radar.
Any long position in the VIX or related products requires time and price stops. A rate cut over the coming weeks and months that sends the stock market high would likely cause the VIX to drop to a new 2024 low. Meanwhile, the turbulent economic and geopolitical landscapes could cause the stock market to fall in the blink of an eye. Given the range since 2008 and the current level, risk-reward dynamics favor the upside for the volatility index.
Tight stops and the willingness to accept small short-term losses in the quest for oversized profits when the VIX next explodes higher could be the optimal approach to trading the instrument below the 14 level and far too low in the current environment.
On the date of publication, Andrew Hecht did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
