What Can We Learn From The Volatility Index?

The name 'Volatility Index' gets thrown around a lot. Where is the VIX? What did the VIX do today? The market doesn't bottom until the VIX does _____. We see a lot of numbers mentioned around The Street, but I haven't seen any evidence that these VIX targets mean anything at all over the long-term.

So the way we use the Volatility Index is as a negatively correlated asset to US Equities. It's really simple: VIX goes up, Stocks go down. VIX goes down, Stocks go up. Here is the chart showing the strong negative correlation over the last year:

So if we can get clues about the direction of the VIX, we can then use that information to help make stock market decisions. This chart below gives us a much closer look at the volatility index with a few annotations. The first is the downward-sloping 200 day moving moving average that the VIX couldn't stay above last week. That higher high and false breakout that could not hold after those horrible June 1 job numbers stalled at a key Fibonacci level. The black dotted line represents the 38.2% retracement from the early August high of $48 down to the mid-March low in the $13's. Look at the intraday breakout attempt and failure on Monday, June 4th.

To make things worse for the VIX, as it tried to breakout putting in that higher high, the Relative Strength Index was already rolling over. This lower high and bearish divergence in RSI makes the VIX even more vulnerable at these levels.

With the strong negative correlation that the VIX has with US Stocks, we'll chalk this one up as more bullish action for the stock market. This is also a positive for risk assets in general.

So we'll watch these key levels and make sure that the price of the VIX remains below it. As long as that's the case, we want to stick with a risk-on mentality.

Also See:

Using Intermarket Relationships to Measure Risk-Appetite (June 9, 2012)

These Two ETF Pairs Are Showing Bullish Divergences (June 11, 2012)

Tags: $VIX $SPY $VXX $SPX