How the VIX Telegraphed the Market’s Top

It’s been a good run this year for the U.S. stock market. Now we’re seeing somewhat of a pullback. No surprise, really. Stocks can’t just keep going up forever. And, it’s really no surprise when one considers what’s been going on with the VIX lately.

The CBOE Volatility Index, or VIX, measures buying and selling pressure in options on the S&P 500 index, the SPX. When the VIX rises, options are getting more expensive due to traders buying options. When the VIX falls, options are getting cheaper as traders sell options.

Typically, there is an inverse relationship between the VIX and the SPX. When SPX rises, the VIX falls. When the SPX falls, the VIX rises. These two indexes are usually strongly inversely correlated. But not lately. In the past month, there have been many days where the VIX and the SPX moved in the same direction, either both rising or both falling. That’s uncommon. The divergence from its typical trading pattern telegraphed to some traders this current market pullback. To understand why, let’s take a look at the reason this relationship changed.

Usually, when the market falls, investors buy options for protection—out of fear—pushing up the VIX. And when the market rises, traders sell off that perceived-to-be-unneeded protection and sell options to generate income, pushing the VIX down. But that psychology has been different lately. Traders have been buying options when the market rises and selling them when the market falls. That’s because the fear is to the upside. Specifically, the fear of missing a continued rally.

After the market’s powerful climb this year, many investors have gotten skittish that a top was nearing. They were hard pressed to sink new money into stocks. Do you want to be the guy who bought the top?! But what if the rally were to continue. You gotta be in it to win it! So when the market rallied, investors bought calls so they didn’t’ miss the boat and kept the bulk of their cash safe. Calls gave traders limited risk in case the market turned around and headed south. Calls are a hedge. Specifically, calls are a hedge against not being in the market. They protect cash, while enabling upside participation.

The recent character of the VIX illustrated to investors (investors who knew how to read it) just how cautious traders have been lately. How non-committed the market in general has been. The market couldn’t continue its climb without buyers supporting it with continued fervor. A pullback had to follow. And, indeed it did and is continuing to do so.