MARKETS SPECTATOR: All eyes on the fear index

Recent price action on the VIX shows investors are less worried about downside risk, and may signal a bottom to the recent sell-off.

Unusual moves in the volatility index – or fear index, as it became better known as during the GFC – point toward a bottoming in markets.

During the wild ride that was the GFC, big moves in the indices meant big inverse moves in the VIX.

However, looking at the price action in the VIX last week paints a more positive picture than what we’ve become accustomed to.

Firstly, the volatility index represents the market’s expectation of stock market volatility over the next 30-day period. It’s a measure of the prices that investors are willing to pay for S&P 500 put options to protect the downside risk of their portfolio.

So when people are getting really worried about the downside risk, the VIX rises substantially as more and more people are looking to buy portfolio insurance, which drives the prices up.

On Thursday last week, the S&P 500 index was down more than 1 per cent, which would usually translate into a rise of more than 4 per cent in the volatility index.

However, the VIX actually fell more than 4 per cent, as we can see by the blue arrow in the below chart. This indicates that participants aren’t overly concerned about further downside risk and subsequently aren’t purchasing downside protection for their portfolios.

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Source: StockCharts.com

So, based on this we may actually be nearing a bottom in the recent sell-off. We’ll need to keep a close eye on price action but Friday’s day of indecision on the S&P 500 showed that the bears had lost complete control.

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