Fear and Greed – VIX rules
Most economists will tell you that stock prices are determined by supply and demand and that free markets, being efficient, will always yield the correct price or value for a company. However there are instances where the market is NOT efficient and fluctuations in price can vary, in some cases wildly. This is why speculators buy and sell hoping to take advantage of the price swings.
One method of measuring these inefficiencies is through the number of put and call options that are traded on the S&P 500 shares. This is a measure of the volatility of the market. If you’re not familiar with the Chicago Board Options Exchange Volatility Index don’t feel bad. Many people don’t understand what it means or how you should act upon its moves.
Put simply, when investors are betting on the market going higher, the VIX responds by heading lower. When investors are taking the market down, the VIX moves higher. This is why it is sometimes referred to as the “fear index” because when investors are fearful this index rises. And of course, the reverse is true when investors are complacent (or greedy).
So we have just had a very nice (and long) run up in the markets. Where would you think that the VIX stands? Well, it started in 2010 with a string of down days – all the way down to a 19-month low today, in fact. (It’s currently trading around 16 points, which isn’t historically low, but low enough to indicate complacency among investors.)
Which is exactly when I start to get nervous. When complacency reigns, the market has a way of getting everyone’s attention again (i.e. – a turnaround is imminent).
And when the market turns, the VIX blasts to the moon quickly, usually much faster than it falls. (This tells us that investor fear is stronger than investor greed).
So here’s the rule of thumb:
- When the VIX is between 10 and 15: Sell stocks.
- When the VIX is over 40: Buy stocks.
- When the VIX is over 50: Buy more stocks.
- When the VIX is between 60 and 70: Take out a second mortgage and load up.
Again, the VIX sits at around 16 right now – very close to a sell signal, which is why I suggest you pay close attention (and adhere) to your sell stops.
