The VIX - What It Means

The VIX measures the implied volatility of the S&P 500 for the next 30 days using the pricing on various options.  Some people use it as a signal to gauge the market.  You should determine the value it as to you.  By the way, the author of this article is Steven Sears who has written a really good book on investing titled The Indomitable Investor.

The article is in italics.  From Barron's:

Anytime anyone wants to say something seemingly insightful about stock trading, the CBOE Volatility Index (ticker: VIX) is trotted out. The options market is filled with the smartest stock investors, and this index supposedly reflects what they are doing.

Of course, it increasingly seems that those who most discuss the VIX understand it the least, which ironically creates a self-fulfilling cycle in which everyone asks about the VIX, lest they are missing some profound market signal.

IF THE VOLATILITY INDEX IS HIGH, it often means that investors are too scared about stocks, and it's a good time to buy them. If it's low, as it is now, it is often a sign that investors are too complacent, and that smart ones should be afraid. But conventional interpretations aren't always accurate. Now is such a time.

While the options market's fear gauge dropped to 13.22 during the week, its lowest level since late June 2007, the VIX is behaving as it should when stock prices slowly grind higher. There is no more profound meaning in the VIX.

Slow stock rallies expose the options market's Achilles' heel. Because implied volatility—what is likely to happen in the future—is influenced by realized volatility— what did happen in the past—options-pricing formulas conclude that the future will be like the recent past.

This is a key reason why the VIX is at about 13. The historical volatility of the Standard & Poor's 500 index, upon which the VIX is based, is 8.1 over the past five days, and 12.7 over the past 30 days. In this context, the volatility gauge, which is designed to give a 30-day forward market view, is in sync with the market.

"The lack of crazy is notable," says a top options-trading strategist. "Volatility has been low. The stock market has been up, and that jibes with conversations we're having with clients who tell us they're not worried."

Indeed, options-trading patterns suggest that defensive put buying to hedge stock portfolios essentially has disappeared. Loads of bearish puts were bought in case the stock market plunged over the fiscal cliff on Dec. 31. Hedges that were set to expire this month have been allowed to do so, or have been closed. This influences the VIX because put buying heavily influences implied volatility.

If the options market has any message for investors, it is that stocks—and thus the CBOE Volatility Index—are stuck in purgatory. Even though Wall Street's banks have just published reports saying stocks will—surprise! surprise!—rally higher in 2013, 2012's dynamics are still in place. Concerns about global economic growth and the March 1 debt-ceiling deadline are capping the stock market's upside, while central-bank intervention is limiting the downside. By mid-February, the VIX probably will edge higher, as investors prepare for the debt-ceiling debate.

The real meaning to extrapolate from the VIX's decline is that bearish puts and bullish calls aren't trading with fear-and-greed premiums. With many stocks near 52-week highs, puts and calls now offer cost-effective ways to wager on earnings. Many investors are doing just that ahead of this week's stream of earnings reports from major banks, including JP Morgan Chase (JPM) and Bank of America (BAC).

THE TRENDY TRADE IS TO PLAY bank earnings through inexpensive puts and calls on the Financial Select Sector SPDR (XLF).

With XLF at $17.08, investors are buying Jan. 17 calls to prepare for an earnings rally, and Jan. 17 puts in case of a decline. The trading is uninspired, and perhaps even dull, but it is a sign of the times.