The VIX Breaking 20 May Not Be Good News; How Investors Can Protect Themselves

The recovery in the major indices since stocks found what looks like a bottom in October has been consistent given the amount of uncertainty that surround the economy, not just here in the U.S., but around the world. There was a period of weakness in December, but most believe that was as much about tax loss harvesting as it was any concern about fundamentals. This month, stocks have bounced back strongly from that pullback. As they have done so, a much-watched indicator of potential trouble ahead, the VIX, has fallen quite dramatically and is now below a significant level.

That, however, may not indicate what a lot of people seem to think it does.

Anybody who has been around stocks for a while is probably aware of the VIX. It measures the implied volatility in stock options and is sometimes referred to as Wall Street’s “fear index” -- the higher the number, the greater the level of fear. It is calculated based on S&P 500 index options, both calls (options to buy) and puts (options to sell), and a number above 30 is usually seen as an indication of turbulence ahead, while a print below 20 indicates an upcoming period of relative stability.

When the VIX broke through the 20 level earlier this week, it was seen by most people as a positive sign. The 1-Year chart for the VIX, however, suggests otherwise:

Figure 1: Vix 1 Year

On the chart above, I have marked that 20 level with the horizontal blue line, and the breaks below with the white arrows. As you can see, on all four previous occasions that the VIX has broken below 20 over the last year, it has rebounded quite sharply. A chart for the S&P 500 over the same period, with arrows on the same dates, clearly shows what that has meant for the stock market:

Figure 2: S&P 500 1 Year

I hate to be the bearer of bad news but those two charts, taken together, don’t look good.

In fact, based on that, a break below 20 on the VIX is a pretty reliable leading indicator of a drop in stocks. With the Fed meeting on February 1, it is looking less likely after this week’s data that they will change their generally hawkish tone. I said as much yesterday, but also said that the market seems to be taking that probability in its stride. Longer-term, I still believe that to be the case, but, based on the charts above, any negative reaction to the Fed’s decision or their comments after the next meeting could well be exaggerated, and February looks like it could be a rough month.

If that is what shakes out, what should investors be doing to prepare for that possibility?

One answer would be to reposition your portfolio, selling stock or moving your portfolio towards “safer,” less volatile holdings. However, given that the facts point to a pullback being only temporary, it may be better to just take out some form of short-term insurance. You could do that by buying the VIX itself, or rather something that reflects movement in the index like, say the iPath Series B S&P 500 VIX Mid-Term Futures ETN (VXZ).

Figure 3: VTX 1 Year

Before we go any further, though, I have to point out that if you take that route, there are a couple of things you need to know.

The first is that the VIX is inherently leveraged, and as you can see from that first chart up top, swings can be big and momentum builds quickly. That is useful if the VIX does as it has over the last year and bounces back after a break of 20, enabling you to hedge your portfolio effectively with a relatively small outlay. But the big caveat is that the reverse is also true -- it will quickly work against you if the index continues to drop. That makes it important that you set, and stick to, stop loss orders if you buy something like VXZ.

Second, if you look at Figures 3 and 1 together, you will see that VTX doesn’t exactly mirror the VIX. That is because the high expenses of running a fund that tries to track futures contracts causes an ETF like VYX to lose value over time. For a short-term hedge, that isn’t important, but it means that any purchase of the ETF needs to be exactly that: short-term. This is not something to buy and hold.

With those two things in mind, and with history suggesting that the break of 20 on the VIX signals a coming drop in stocks, buying something like VTX to own for a couple of weeks or so looks like a sensible precaution.

* In addition to contributing here, Martin Tillier works as Head of Research at the crypto platformSmartFI.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Other Topics

Economy Stocks ETFs