Using VIX to Predict Market Direction

The Volatility Index, also known as the VIX or the Fear Index, is a tool often remarked by investors and traders. It is a measure of implied volatility, as a per cent, and is used by many to determine where the market may be headed in the next month. A high VIX, above 30, suggests that market volatility is occurring and the market may be headed downwards. A low VIX suggests the market will remain calm and potentially be positive for the next month.

However, I have found that the VIX is a very reactionary index. Having traded the VIX options many times, one will recognize that the VIX makes significant moves only when the market has a large move in one day. A 200-point drop in the Dow may move the VIX up 2 or 3 points. Many would say that this rising VIX suggests more volatility ahead, but this is not always true.

Today, the Dow opened 110 points lower, with the VIX reacting, peaking at 27.32 up 3.19 points. As the day progressed, the Dow pared losses and flirted with positive territory, thus the VIX sank to back 24 and change. As you can see, it's not a very good tool to measure volatility if it's a reactionary device, but this is where the VIX options come in to play.

Using the VIX options to predict the market's next move is something I have been using ever since I noticed its strange behaviour and pricing back when I worked at the brokerage. It's good for those that have trouble with technical analysis or get caught up in emotional trading. Deep in-the-money options often paint a nice picture of the market's next move. Here's how it works.

First, we simply find the value of the VIX, ignoring its level and its "meaning." Then, we use the front-month options. If the VIX options expire in a few days, check the following month contracts. Find the deep in-the-money options and you will notice that either the calls or the puts will be under priced. That is, it will be missing intrinsic value. That missing intrinsic value will eventually be filled by a move in the VIX. This move can then be interpreted as a reactionary move against the market. Make sense? Here is an example using today's options level.

The VIX is currently at 24.19. So, let's check the August18 calls and puts. If the VIX were an actual security, we would know that the 20 call should be worth at least 4.19 and the 30 put should be worth at least 5.81, but the VIX does not trade like that. In fact, the 30 put is only worth about 5.30, missing intrinsic value of 0.51. This will mean that the VIX may move up 0.51 to correct this option mispricing. A move up in the VIX indicates a short-term down ward move in the stock market.

This is not a fool-proof method, but has proven more often than not to be accurate. Today is July 30, and the Dow is 10,421 as I write this. I am making a bold prediction using this technique that we will see it be worth less in the next few days.