The VIX Index

A tale of many possibilities for the stock market

Well folks, let's talk about the stock market. With the recent bank failures, Ukraine war and other depressing news lately, you'd think the stock market would be in the gutter by now. But no! Like a old truck that won’t give up, the market has been relatively stable given these circumstances, proving once again that the old adage 'the market climbs a wall of worry' is no joke. At time, it's seemed like a wild ride, with the market bouncing around in the same range for the past 12 months like a kangaroo on a pogo stick. But hey, at least we're not bored, right?

One way of seeing just how boring this market has become is looking at the VIX index.

The VIX index, also known as the "fear index," measures market volatility and is designed to reflect the market's expectation of 30-day forward-looking volatility. It is based on the price of options on the S&P 500 index, and it typically rises during times of market uncertainty and falls during periods of stability. A 20% drop in the VIX index would indicate a significant decrease in market volatility.

Given the recent 20% fall in the VIX this April, I asked ChatGPT the following questions about the VIX index.

Prompt: How many times has the VIX fallen by 20%?

Response: It is difficult to answer this question definitively, as the VIX (the CBOE Volatility Index) is a relatively new index and its history is limited. However, according to trading data from the Chicago Board Options Exchange, the VIX has fallen by 20% or more on at least 19 occasions since its inception in January of 1993.

Prompt: Of the times the VIX has fallen by 20% of more how did the S&P 500 index perform each of those times? Response: According to trading data from the Chicago Board Options Exchange the S&P 500 Index has typically performed positively following a 20% or more decline in the VIX. Between January 1993 and April 2020, the S&P 500 Index has risen an average of 6.7% within the first three months after the VIX has reached a 20% decline.

I Tweeted about this in my most recent post.

Here is the transcript from my ChatGPT session….

Based on the accuracy of the data provided by ChatGPT (which I am paying for) and assuming history repeats itself in this situation, a 6% rise would correlate to an increase in the S&P500 index from $4,127 to $4,374.

Real Volatility vs Implied Volatility

The obviously begs the question, is this time different? Which leads me to the next part of this article, Real Vs Implied Volatility.

Real volatility, also known as historical volatility, is a measure of the actual fluctuations in the price of an asset over a specified period of time, typically calculated using the standard deviation of the asset's returns. Real volatility is based on past market data and is therefore a backward-looking metric.

On the other hand, implied volatility is a forward-looking measure of the expected volatility of an asset over a specified period of time, as implied by the current market price of options on that asset. It is calculated using an options pricing model, such as the Black-Scholes model, and is influenced by factors such as market sentiment, supply and demand for options, and the perceived risk associated with the underlying asset.

Real volatility is a measure of past price movements, while implied volatility is a measure of expected future price movements based on current market data and investor expectations. Implied volatility is often used by traders and investors to assess the potential risk and return of an investment, while real volatility can provide insight into the historical risk and return of an asset.

The VIX index measures implied volatility.

Bollinger Bands on VIX

Well folks, let's take a gander at the VIX chart with a technical overlay I like to use called Bollinger Bands.

Bollinger Bands are a popular technical analysis tool used in financial markets to measure the volatility of an asset's price relative to its moving average. They consist of three lines: a middle band, which is usually a 20-period moving average, and an upper and lower band, which are typically two standard deviations away from the middle band.

The upper and lower bands are meant to serve as a statistical measure of the price volatility of the asset being analyzed. When the price of the asset is relatively stable, the bands will be closer together, whereas when the price is volatile, the bands will be further apart.

Traders and analysts often use Bollinger Bands to identify potential buy and sell signals. For example, if the price of an asset approaches the upper band, it may be considered overbought, and a sell signal may be generated. Conversely, if the price approaches the lower band, it may be considered oversold, and a buy signal may be generated.

Bollinger Bands can be used on any type of asset or security, including stocks, bonds, commodities, and currencies. However, it's important to note that like all technical analysis tools, Bollinger Bands should be used in conjunction with other analysis methods and not relied upon as the sole basis for making investment decisions.

When this bad boy breaks out of its upper Bollinger Band (green line), it's like a cat on a hot tin roof - there's panic in the streets, traders running for cover, and a general sense of chaos in the air. But fear not! Like a faithful watchdog, volatility always comes back to its master and the market settles down to a nice, cozy range. On the flip side, when the VIX slinks below its lower Bollinger Band (white line), it's like a bear hibernating for the winter - all quiet on the surface, but danger lurking just around the corner. So keep your eyes peeled, folks, because the lower Bollinger Band is currently snoozing at $12.69, and you never know when it might wake up and decide to throw a party!

Note - If the VIX were to touch the lower Bollinger Band on the monthly chart (which is very rare) would require another 35% drop in the price of the VIX.

Let’s look at the daily chart going back a year and see how it differs. As you can see by the chart above the lower Bollinger Band is at $16.12 which would only require a 6% drop in the VIX to reach that level.

Now, overlay this information with what we spoke about earlier.

Looking at the month of April you can see that the S&P closed at $4,109 the last trading day of March, and reached it’s monthly high of $4,165 on April 18, 2023. Far shy of the 6.7% average usually achieved in the S&P 500 when the VIX drops by 20% or more!

Ah, the eternal debate between the bulls and the bears. It's like watching a couple of grizzlies fight over a salmon, isn't it? On one paw, the bears are saying that this consolidation is just the calm before the storm, and any minute now the VIX will shoot up like a rocket ship and take the market down with it. On the other paw, the bulls are saying, 'Nuh-uh, we're just catching our breath before the next leg up, baby! We're gonna break out of this range like a racehorse out of the gate and make that sweet, sweet 6.7% return.' And then you have the neutral party, sitting on the sidelines like a wise old owl, saying, 'Let's not get ahead of ourselves, folks. We might just be stuck in this range for a while longer. Who knows? Maybe we'll all turn into prairie dogs and hibernate for the winter.' So, what's next? Your guess is as good as mine, my friend.

Thanks for reading Tief’s Takes, brief memos to help you navigate financial market conditions, the economy, blockchain, cryptocurrency and personal finance. If you have been enjoying my newsletters please consider subscribing to my premium services today and help support my work!

Jeffrey J. Tiefenthaler is the founder of Trading Tech and Consulting LLC. He is an experienced FinTech entrepreneur, accredited investor, and brand ambassador with two decades of experience trading in US stock and options markets, 15 years consulting for Microsoft brands such as Xbox, Windows and Office. He’s been featured in CoinMarketCap and awarded number one for articles with the highest views, top 10 for projects by Engagement Growth, top 10 for projects by community followers gained.

PS - I wrote this article with the help of AI using my new skill - prompt engineering =-)