The Volatility Index VIX is one of the most popular methods for determining stock market emotions. In full, it stands for CBOE Volatility Index, the volatility index of the Chicago Board Options Exchange.
The market is an emotion, always has been, always will be. Robots? Great, but they are created by people with emotions. And a trader needs a method that allows him to identify these emotions. That's where the VIX index comes in. It is based on the volatility of options on the S&P 500 Index. Yes, yes, it's actually an index for an index, this happens in the markets. The VIX index is also known as the Fear and Greed Index.
The index is expressed as a percentage and indicates the probability of the S&P 500 index moving over a period of 30 days, where the probability level is 68% (one standard deviation from the normal distribution curve, aka the Gaussian curve). Let's say that if the VIX is 15, therefore the expected change in the S&P 500 index over the course of a year, with a 68% probability, is less than 15% up or down.
What does that have to do with emotion? For that, we need to understand the forces that underlie any strong market movement.
Greed is the desire to possess more and more than is really needed. Whether it be money, goods, services, or any material values.
According to a number of scientific studies, greed is the product of a chemical reaction in our brains that causes common sense to be discarded and sometimes causes irreversible changes in both the brain structure and the body. Perhaps someday a pill for greed will be invented, but for now, everyone is greedy without restraint.
Greed is as addictive as smoking or drinking alcohol. "He has pathological greed," "he's the greediest guy the world has ever seen," are all victims of a very common mania.
The average trader comes to the market and he is subjected to the strongest emotional influence, caused by the very brain "chemistry". He wants more and more and more, all the time. He wants more numbers on the account. He can't stop, he can't control himself. As the result, brokers and different near-market agents use this obsession with pleasure, exploiting his mental disease.
Similar effects are associated with the emotions of "happiness" and euphoria. As a result, such traders' brains are constantly bombarded with emotional temptations and endless financial carrots, just as narcotic substances give the effect of not getting high at all but of temporary relief.
The dot-com bubble
This is a classic example of market greed. The Internet bubble led to millions of investors continuously pouring money into Internet companies between 1995 and 2000, despite the fact that most of them had no future.
It got to the point of absurdity. Some companies were getting hundreds of millions of dollars just for creating the website "XYZ dot com". Greed bred greed, led to a colossal overestimation of assets and their real value. Investors, obsessed with making easy money, invested insane amounts of money in nothing. The inflated bubble naturally burst and took all the money of the greedy people with it.
The Financial Crisis of 2008
The book "The Big Short: Inside the Doomsday Machine" by Michael Lewis (and the movie "The Big Short ") tells the story of how a few people profited from the massive greed of others. An instrument like CDS (Credit Default Swap) turned into a crazy financial pyramid scheme with a turnover of over $62 trillion. In the financial crisis of 2007-2010, the volume of this market shrank threefold another bubble driven by greed and obsession burst at the seams, and the financial world shuddered and shrank dramatically. Only a few people made a fortune as they worked against the greed of the crowd.
Fear
An uncomfortable state of constant stress, waiting for the worst fate and constant threat. The dot-com bubble also demonstrated this emotion well. To cope with the horrific results of the dot-com bubble, out of fear, investors took money out of the stock market and put it into the safest possible instruments, like stable investment funds or government-backed funds. These funds were not very profitable, but their main advantage in the eyes of investors was minimal risk. This is an example of how investors ruined all of their long-term investment plans because fear forced them to hide their money literally under their pillow. These assets did not generate income, but remained conditionally safe.
How to read VIX
The correlation between the VIX and the S&P 500 is quite clear. Let's compare the values, where the blue line is the VIX and the orange line is the S&P 500.
As we can see, a decrease in the VIX corresponds to an increase in the S&P 500, while an increase in the VIX (fear) in contrast is a signal of a collapse of the S&P 500.
Statistics show that there is an inverse correlation between the VIX and the S&P 500, as the VIX moved in the opposite direction from the S&P 500 more than 80% of the time between 2000 and 2012.
Where the VIX peaks, there is a decline in the S&P 500 and all the associated effects that affect both the dollar and other currencies.
So, if the VIX is less than 20, investors are less worried, the volatility of the S&P 500 is expected to be low.
If the VIX is greater than 30, investor fear increases as option prices on the S&P 500 rise; hence, investors pay more to hedge their assets.
A typical picture is, for example, the VIX is at an ultra-low 10 and the S&P 500 is breaking new growth records. This is all an indication of an impending collapse of the S&P 500. However, if the Central Banks change monetary policy accordingly, this VIX level could very well become the new "normal" value.
One scenario to use is to wait for the VIX to consolidate above 30 and enter the SPX on its decline. When investors have a scare, it's an indication of a panic sell-off.
Let's look at some real examples. Since the beginning of this year, the VIX Index has been hitting fear records, reaching a high of 30. In theory, this means a drop in the SPX index.
Well, why in theory? In practice it worked out 100%, the SPX index really collapsed spectacularly.
Conclusion
As we know, the S&P 500 index, which we have already studied, is the "king" index. It not only shows the state of the U.S. economy and stock market, but also indirectly shows the state of a mass of other assets, from interrelated indices to the value of the dollar. Because of correlation, Fear and Greed indices can be adapted to everything, both indices and currency pairs. It is one of the most popular stock indicators, unique in its kind and actively used for long-term market forecasts.
The market is an emotion, always has been, always will be. Robots? Great, but they are created by people with emotions. And a trader needs a method that allows him to identify these emotions. That's where the VIX index comes in. It is based on the volatility of options on the S&P 500 Index. Yes, yes, it's actually an index for an index, this happens in the markets. The VIX index is also known as the Fear and Greed Index.
The index is expressed as a percentage and indicates the probability of the S&P 500 index moving over a period of 30 days, where the probability level is 68% (one standard deviation from the normal distribution curve, aka the Gaussian curve). Let's say that if the VIX is 15, therefore the expected change in the S&P 500 index over the course of a year, with a 68% probability, is less than 15% up or down.
What does that have to do with emotion? For that, we need to understand the forces that underlie any strong market movement.
Greed is the desire to possess more and more than is really needed. Whether it be money, goods, services, or any material values.
According to a number of scientific studies, greed is the product of a chemical reaction in our brains that causes common sense to be discarded and sometimes causes irreversible changes in both the brain structure and the body. Perhaps someday a pill for greed will be invented, but for now, everyone is greedy without restraint.
Greed is as addictive as smoking or drinking alcohol. "He has pathological greed," "he's the greediest guy the world has ever seen," are all victims of a very common mania.
The average trader comes to the market and he is subjected to the strongest emotional influence, caused by the very brain "chemistry". He wants more and more and more, all the time. He wants more numbers on the account. He can't stop, he can't control himself. As the result, brokers and different near-market agents use this obsession with pleasure, exploiting his mental disease.
Similar effects are associated with the emotions of "happiness" and euphoria. As a result, such traders' brains are constantly bombarded with emotional temptations and endless financial carrots, just as narcotic substances give the effect of not getting high at all but of temporary relief.
The dot-com bubble
This is a classic example of market greed. The Internet bubble led to millions of investors continuously pouring money into Internet companies between 1995 and 2000, despite the fact that most of them had no future.
It got to the point of absurdity. Some companies were getting hundreds of millions of dollars just for creating the website "XYZ dot com". Greed bred greed, led to a colossal overestimation of assets and their real value. Investors, obsessed with making easy money, invested insane amounts of money in nothing. The inflated bubble naturally burst and took all the money of the greedy people with it.
The Financial Crisis of 2008
The book "The Big Short: Inside the Doomsday Machine" by Michael Lewis (and the movie "The Big Short ") tells the story of how a few people profited from the massive greed of others. An instrument like CDS (Credit Default Swap) turned into a crazy financial pyramid scheme with a turnover of over $62 trillion. In the financial crisis of 2007-2010, the volume of this market shrank threefold another bubble driven by greed and obsession burst at the seams, and the financial world shuddered and shrank dramatically. Only a few people made a fortune as they worked against the greed of the crowd.
Fear
An uncomfortable state of constant stress, waiting for the worst fate and constant threat. The dot-com bubble also demonstrated this emotion well. To cope with the horrific results of the dot-com bubble, out of fear, investors took money out of the stock market and put it into the safest possible instruments, like stable investment funds or government-backed funds. These funds were not very profitable, but their main advantage in the eyes of investors was minimal risk. This is an example of how investors ruined all of their long-term investment plans because fear forced them to hide their money literally under their pillow. These assets did not generate income, but remained conditionally safe.
How to read VIX
The correlation between the VIX and the S&P 500 is quite clear. Let's compare the values, where the blue line is the VIX and the orange line is the S&P 500.
As we can see, a decrease in the VIX corresponds to an increase in the S&P 500, while an increase in the VIX (fear) in contrast is a signal of a collapse of the S&P 500.
Statistics show that there is an inverse correlation between the VIX and the S&P 500, as the VIX moved in the opposite direction from the S&P 500 more than 80% of the time between 2000 and 2012.
Where the VIX peaks, there is a decline in the S&P 500 and all the associated effects that affect both the dollar and other currencies.
So, if the VIX is less than 20, investors are less worried, the volatility of the S&P 500 is expected to be low.
If the VIX is greater than 30, investor fear increases as option prices on the S&P 500 rise; hence, investors pay more to hedge their assets.
A typical picture is, for example, the VIX is at an ultra-low 10 and the S&P 500 is breaking new growth records. This is all an indication of an impending collapse of the S&P 500. However, if the Central Banks change monetary policy accordingly, this VIX level could very well become the new "normal" value.
One scenario to use is to wait for the VIX to consolidate above 30 and enter the SPX on its decline. When investors have a scare, it's an indication of a panic sell-off.
Let's look at some real examples. Since the beginning of this year, the VIX Index has been hitting fear records, reaching a high of 30. In theory, this means a drop in the SPX index.
Well, why in theory? In practice it worked out 100%, the SPX index really collapsed spectacularly.
Conclusion
As we know, the S&P 500 index, which we have already studied, is the "king" index. It not only shows the state of the U.S. economy and stock market, but also indirectly shows the state of a mass of other assets, from interrelated indices to the value of the dollar. Because of correlation, Fear and Greed indices can be adapted to everything, both indices and currency pairs. It is one of the most popular stock indicators, unique in its kind and actively used for long-term market forecasts.
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