Do You Know How the VIX Affects Your Investing?

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Professional investors focus on lots of different details. Some focus on fundamentals, some focus on price action, some look at both. Every investor is looking for an edge. If you can figure out what other investors are thinking, you have a definite edge.

That's why many professionals focus on the VIX.

So I know what you're thinking, what's the VIX? The VIX is a measure of volatility in put and call options on the S & P 500.

It was originally introduced by the Chicago Board Options Exchange (CBOE) in 1993. It's now widely used as a measure of market volatility. . . basically a measure of "Fear and Greed".

So, how's it measured? The answer to this is a bit more complicated. Entire white papers have been authored on this subject. I could spend hundreds of pages describing in detail the theory and thought behind the VIX. So here's the short version.

The VIX takes a basket of options looking about 30 days into the future. Then a measurement of the changes in value of puts and calls is made. Taking this data, and a fancy algorithm, they're able to calculate the price of the VIX. Using today's computer technology the calculations are done continuously throughout the day.

I know that's confusing.

What you really need to know is this.

The VIX is a measure of "Fear and Greed". When investors become fearful, they tend to pay more for options. This makes sense. Buying and selling options are an easy way to hedge your exposure to the market. When investors are fearful option prices increase and the VIX goes up.

The volatility in the last few months has been crazy. Investors are fearful. Investors became really fearful – starting in July of 2007.

You know as well as I do the Dow was over 13,600 at that time. Everyone knows what's happened since then. The Dow fell to 12,000 over the next few months.

Historically, when values ​​on the VIX are greater than 25 the markets are unsettled and investors are fearful. The last time the VIX was above 25 was in 2002. . . and we all know what was happening in the markets then. When the VIX is below 20 the markets are reliably calm.

Now I look at the VIX every once in a while to get a grasp on market sentiment. I've noticed something recently. In the last few months the VIX has been heading lower. As a matter of fact, it's fallen almost 45%.

This tells me that investors are becoming less fearful. While never a perfect indicator, it could lead to higher levels in the major market indices in the coming months.

As a result, I'm cautiously optimistic about an intermediate term rally in the markets. Possibly starting as soon as this fall.