The market is rising, but not as quickly as the VIX is diving. And that could be great news for the month ahead.
As the S&P 500 has rallied over the course of the week, the CBOE Volatility Index has plummeted more than 25 percent from its recent highs. With the July Fourth holiday weekend approaching, it's not uncommon to see the VIX move lower.
After all, the VIX measures how much people are willing to pay for options on the S&P 500, and options prices drop to account for the smaller number of trading days than normal in the month of July.
However, the move in the VIX might be telling us a bit more than how many days are in the next month. It might be signaling that the market is gearing up for a whoosh higher.
Before I explain why, let's zoom out for a second. As an investor, why even watch what the VIX is doing? For a geeky quant trader guy like myself, the VIX speaks volumes about the pricing of options. However, to the average investor, the VIX can bring another meaning: It is a tool used to assess fear in the market.
Using the VIX as a fear gauge can help investors understand when institutions and big market participants are shifting their sentiment from the current market trend, and are beginning to take the opposite side of the order flow.
When we look to put money to work for our clients, the VIX is a good indicator of when we should buy dips and sell rips. Why is that? Because VIX helps tell us the health of liquidity in the market.
We know that markets typically fall fast and rise slow, and that the VIX should remain negatively correlated to the market. This makes sense: As the market drops, people scramble to buy protection, inflating options prices.
But when this relationship breaks down—when the VIX starts to move in the same direction as the S&P 500, or when the VIX stops rising quickly on down moves in the S&P 500—it can infer that a trend change is about to happen.
So what does it tell me that the VIX fell 25 percent off of a 3.4 percent rise in the market? It indicates that some traders are dipping their toes in the market by selling out their insurance (held in the form of puts).
This is encouraging, and tells me that if we can just push above resistance at the 50-day moving average, we might at least move to 1,650 in the S&P 500.
Normally, I'd love to see a retest of the lows while the VIX makes a lower high, and we haven't quite gotten that clear of a sign to buy into the market with a ton of conviction. However, Friday's move should at least put a pause in the recent selloff.