After a monstrous rally in June and July so far, as the market recovered all of its May losses and has repeatedly chronicled fresh highs, stocks have reached unforeseen heights.
Amidst this market, which continues to defy naysayers, the VIX, often an indicator of investor sentiment, has settled around the 11-12 level, showing investor complacency. But sometimes the quiet leads to a storm of activity quite unexpectedly.
The Volatility Index, or VIX, an instrument created by the Chicago Board Options Exchange (CBOE), is a real-time market index that represents the market’s expectation of a month period of forward-looking volatility. In most cases, the higher the volatility, the riskier the security. Derived from the price inputs of the S&P 500 index options, the VIX provides a measure of market risk and investors’ sentiments. It is also known by other names like “Fear Gauge” or “Fear Index,” as investors, research analysts and portfolio managers generally look at VIX values as a way to measure market risk, fear and stress before they take investment decisions.
While muted market fears might seem auspicious for the time being, the VIX could essentially be a ticking time bomb, says Sven Henrich, founder and lead market strategist at NorthmanTrader.
“The VIX follows some very specific patterns that show compression,” Henrich said Friday on CNBC’s “Trading Nation.” “If you look back to, let’s say, the last few years, we’ve seen a large compression pattern from 2016 to 2017.”
“When that energy compresses too much, then we see these spikes,” the strategist said. “We have seen these spikes with quite a bit of regularity, but they always need some sort of trigger, and perhaps the Fed may be the trigger next week.”
Exchange traded products that track the CBOE Volatility Index, or VIX, surged Monday as volatility experienced its sharpest daily jump in over a year in response to President Donald Trump’s threats to raise tariffs on Chinese imports ahead of a trade meeting in Washington recently for example.
On that Monday, the iPath Series B S&P 500 VIX Short Term Futures ETN (VXX ) jumped 8.9%, ProShares VIX Short-Term Futures ETF (VIXY ) increased 8.8% and VelocityShares Daily Long VIX Short-Term ETN (VIIX ) advanced 8.8%. Potential investors should keep in mind that VIX-related exchange traded products track VIX futures and not the spot price.
The upcoming Fed meeting could portend another such move.
“It’s compressing tighter and tighter, and it’s building up this pattern,” Henrich said. “So, it’s ready for another breakout. The question is the when and the how.”
Investors who are weary of a VIX breakout could look into alternate asset allocations such as bond ETFs like the iShares iBoxx Investment Grade Corporate Bond ETF (LQD ) or a gold ETF like the SPDR Gold MiniShares (GLDM) and SPDR Gold Shares (GLD ).
However, those who believe the VIX will continue to languish or move lower could explore an ETF such as the ProShares Short VIX Short-Term Futures ETF (SVXY ), which follows the inverse or -100% daily performance of VIX futures.
For more information on the CBOE Volatility Index, visit our VIX category.