What Investors Can Learn From the VIX

Professional managers use it as a short-term trading opportunity. Should you?

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The market has been on a fairly steady upward trend this year, except for a stumble in mid-March following the devastating earthquake and ensuing tsunami in Japan. So far this year, the S&P 500 has returned about 7 percent, and the Dow Jones Industrial Average is up almost 9 percent. That's likely a reason many investors have become complacent, which is reflected in one of the market's most closely watched indicators, the Chicago Board Options Exchange Volatility Index, or VIX for short.

The VIX uses options prices to measure expected volatility in the S&P 500 over a 30-day period. It's often referred to as the "fear gauge" because it measures how fearful or complacent investors are at any given time. Professional money managers often use the VIX as a hedge against volatility because the VIX generally moves in the opposite direction of the S&P 500. Investors can follow the VIX on the Chicago Board Options Exchange website.

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This year, the VIX peaked around 31 in March after the earthquake in Japan, but it recently hit lows not seen since the last bull market in mid-2007. The VIX closed at 14.69 on April 21, the lowest level since July 2007, according to TrimTabs Investment Research. Some experts say that low number indicates that investors have become far too complacent in a market that faces many challenges, including higher oil prices, unrest in the Middle East, and growing inflation concerns globally.

"The market has moved up almost every day, and it's very easy to get lulled into that complacency," says Harry Rady, CEO of Rady Asset Management, a San Diego, Calif.-based investment management firm. "But that's the time when you want to have your guard up, because the market has a way of chewing investors up and spitting them out when they've been lulled to sleep."

Rady says options are currently cheap, so investors should take advantage. "I would argue that the risks and the potential for geopolitical economic shocks are significantly greater than 2007," he says. Therefore, he expects an uptick in the VIX in the near future. He uses exchange-traded notes, including iPath S&P 500 VIX Short-Term Futures (symbol VXX), to invest in the movements of the VIX. This exchange-traded note, which is a complex debt security that trades like an exchange-traded fund, tracks the S&P 500 VIX Short-Term Futures Total Return Index. It usually goes up or down about half as much as the VIX over a given time period, Rady says.

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It's important to read the VIX numbers in context. Ryan Detrick, senior technical strategist at Schaeffer's Investment Research, says during the last bull market, which lasted from roughly mid-2004 through mid-2007, the VIX trended in the 10-to-15 range. "During the last bull market we saw, a VIX of 15 was actually high," he says. Detrick says he's currently bullish on the market and expects the VIX to continue to fall further, closer to 10.

While it may be beneficial to follow the VIX index to get a read on the level of fear in the markets, it may have limited appeal to individual investors. For starters, experts agree that investing directly in the VIX through exchange-traded notes is only for the most experienced investors. (Currently, there are no exchange-traded funds that invest directly in the VIX.) "Any way you slice it, this isn't a security that can be bought and put away," Rady says. "It has to be traded."

Christian Magoon, CEO of asset management consultant firm Magoon Capital, argues that investors only benefit in times of chaos in the markets. "If you look at the overarching history of the equity markets, there has been extreme events, whether it's a 9/11 or the Japanese sell-off … but the market eventually always recovers," he says. Spikes in the VIX are usually short in duration, and they generally don't affect your investments over the long term.

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Still, it may be useful for investors to follow the movements in the VIX because they can be a contrarian indicator. Magoon says investors should use the VIX like meteorologists use a barometer for predicting the weather. "It's one of the vital signs of the market that gives you a look into the psychology of the market," he says.