Today marks the one-year anniversary of the pandemic-driven market low.
It’s with sardonic irony that the S&P 500 Volatility Index known as the VIX broke key support – $20.
True, this isn’t the first time it crossed or even closed below that price in the past year.
But, this is the first time it did so with conviction.
And it could lead to another major market rally in the near future.
We want to unpack this statement because it’s not as simple as ‘VIX goes down markets go up.’
You need to understand why this time is different and what it means for traders and investors.
Because the rally could be a final fake that sucks johnny-come-latelies in at the top.
And none of us want that.
So, here’s what you need to look for.
What the VIX really means
A lot of confusion surrounds the VIX that we want to clear up first.
Pundits refer to the VIX as the ‘fear gauge’ of the markets.
Why is that?
Well, the VIX measures implied volatility through option demand on the S&P 500.
What most people don’t know is this.
Large funds make up the majority of the option volume on the S&P 500 (not the SPY but the S&P 500). And they tend to favor buying put contracts. Buying put contracts pays them when the market declines, which protects their portfolio of long (owned) stocks.
Think of it as insurance.
Fun fact: This natural bias makes put buying on ETFs and indexes generally more expensive while calls on individual stocks tend to be the opposite.
If big money thinks the market is about to decline or head lower, they demand and buy more put options on the S&P 500. In turn, that drives up the VIX index.
Historically, the VIX trades between $15-$18. Since the market collapse last year, it hasn’t stayed below $20 for any meaningful amount of time.
And the reason for that isn’t entirely clear.
As noted earlier, the index measures option demand on the S&P 500. With retail traders taking a more active role in options trading than ever before, it’s also possible they gobbled up either call or put options.
What we do know is that the VIX rarely stays above historical averages for more than a few months and almost never for a year.
So, dropping back into ‘normal’ territory is a significant achievement.
Short-term market impact
For the most part, markets find temporary tops when the VIX drops too low and bottoms when it climbs too high.
However, a general trend lower in the VIX often coincides with market rallies as long as the lows aren’t well below historical averages (IE near $12 or lower).
So, if we see the VIX close the week firmly below $20, trend followers and market technicians will take that as a sign the VIX will continue lower until it reaches some support level (likely around $17).
Here’s the thing to keep in mind.
The VIX could hit that support level in a matter of days, not weeks. That could lead to a quick rally in equities. But, if the VIX itself stops trending lower, you can bet it will have an impact on the broader market.
Think of it like this…
A certain amount of demand for ‘market insurance’ exists at different price levels associated with the VIX. Each of these points pit sellers against buyers. If sellers cannot overwhelm buyers, the VIX stops moving lower.
Because we know the historical average is between $16-$18, you can bet your bottom dollar that big money knows this as well.
So, it’s reasonable to expect they or others will purchase option contracts on the S&P 500 around that range.
Again, this just creates an area of probabilities, not guarantees.
Turning this into a plan
Knowing what we know, we can draft a plan whether we’re an investor or trader.
Investors can use this knowledge to rotate out of higher-risk positions that turned a profit already.
Traders can either play the possible market rally or wait for the VIX to reverse its trend alongside the major indexes.
None of this is a guarantee this will happen.
Just an analysis of what CAN happen.
And that is the foundation of any comprehensive investment or trading plan.