What Does the VIX Tell Us?

The volatility in the S&P surged to over 20 in the midst of the uncertainty of the fiscal cliff. Now that’s settled the VIX has plunged. However, Americans are getting their first paycheck of 2013 and noticing it’s a bit less than it was in 2012. Wait, I thought the tax hike was only for the top income earnings? Well in the fine print our esteemed members of Congress raised Social Security tax on all income earners 2%. This means the person making $50,000 a year is now paying an extra $1,000 a year in taxes more than they were last year. This is less money to pay your mortgage, your car payment, or your cell phone bill. As people wake up to this fact – what’s going to happen to spending and consumer confidence in already shaky economy where the Fed still feels the need to hold interest rates at 0%?

These are big picture items that are important to keep in mind. Let’s dive into one of my favorite internal indicators the CBOE Volatility Index. See the chart below. The volatility index is often referred to as the fear index. How much fear is in the market right now? Well the VIX is at the lowest levels since 2007 – that’s before the financial crisis. Anytime the fear index gets to extreme in one direction or the other that typically is a great contrarian indicator. A good way to gauge the fear meter is using the Bollinger Bands. When the VIX gets to the higher band that is a sign that bulls are ready to step in and take control of the market and when the VIX is at the lower band bears are ready to take over.

There’s an old adage that says don’t short a quiet market and the market action this week has been quiet. When markets are quiet that is energy building up for the next move and the pot odds favor the downside right now.

This is a good time to sell a call credit spread one strike out of the money in the SPY – the S&P 500 ETF. Go out to the monthly February contracts and sell the 148 call and buy the 149 call as protection for a net credit of 45 cents. Keep an eye on the VIX and look for it to at least get back to the mid line of the Bollinger Bands.