Recently many people have been talking about how often investors have entered the market when the VIX was below 16 only to lose money by buying at the market tops. The assumption that a VIX below 16 is highly correlated to a market top is not always accurate. To fully grasp this concept, one must first understand how the VIX is calculated and how human emotions can affect the VIX.
The VIX is just a volatility measure, nothing more, nothing less. Humans act on greed and fear in the market place and VIX reacts to the actions taken by these two strong emotions.
When the market is rising, we want to capture every possible. People fail to buy protection or insurance in bull markets. As this is occurring, the VIX will remain at depressed levels due to the way it is calculated. As soon as conditions start to change and the market pulls back, everyone runs out to buy protection causing the VIX to rise. When huge amount of S&P-500 (SPX) puts are being bought as investors rush to protect their profits, the VIX will spike.
To illustrate this, let’s look at a few historical charts to see what happens. As you can see, when the VIX is below 16, those who considered either taking profits, staying on the sidelines, and/or shorting the market, would have missed the opportunity to participate in two of the biggest bull markets in the last 20 years. The VIX is the upper subgraph and SPX the lower subgraph. (See Chart 1)
It is clearly shown that if you had bought at any time during these two periods, you would have made a profit.
To take things one-step further, we will be analyzing how many tops or how much money you would have saved if you avoided buying the market when VIX was below 16. (See Chart 2)
You could have saved a small loss by avoiding entering the market when VIX was below 16 once in the last 20 years.
In conclusion, although the VIX is a great instrument to use as an indicator, one must not act on this time series alone. A prudent investor/ trader should utilize other indicators for confirmation in order to make a more informed decision.