VIX, the market's fear gauge, plunges in historic one-week move

VIX sees historic weekly drop

The market's primary measure of fear has cratered, representing a dramatic turnabout in investors' emotional state.

The CBOE Volatility index plunged 42 percent in the prior trading week, in the biggest one-week drop in the history of the index going back to 1990. The move came as markets staged a stunning comeback following the U.K. vote to leave the European Union.

"People were caught flat-footed, " Mark Newton, a technical analyst with Newton Advisors, said Friday on CNBC's "Trading Nation. "

He added: "A lot of people were scared of this decision and started to buy [volatility], but as soon as we figured out that things were OK, then immediately there was a rush to sell implied volatility."

The VIX is often referred to as the market's fear gauge, due to its propensity to capture the extent of trader hedging. The VIX is computed from the prices of options on the Index, and these are more commonly used to protect against downside than to speculate on upside.

While the VIX usually roughly tracks recent volatility (since past volatility is often the best guess at future volatility) something interesting happened last week. Even as actual volatility has increased, the amount of volatility implied by options prices has plunged as the Brexit vote slipped into the market's rearview mirror.

Also helping the VIX to fall has been the substantial 3.2 percent gain for the S&P 500 over the week. Since the VIX tracks market fear, it tends to move inversely to the S&P.

It is worth noting that the VIX's moves are frequently tracked by absolute levels rather than by percentages. Since the VIX never rose substantially above its long-term average level of 20 even amid the Brexit market tumult, the VIX only fell about 11 points in the week. Yet, even that is the largest absolute one-week drop in the VIX since late 2008.

The great irony here involves those who decided to take long positions on VIX-related products like VIX futures and the VXX exchange traded fund (ETF). In anticipation of an unexpected Brexit outcome, these investors have not only seen their big Friday gains erased, but they are actually sitting on losses.

In the view of macro trader Kathy Lien, however, "investors are getting a little complacent," and the Brexit outcome has been pushed under the rug all too quickly.

For Newton, the charts suggest that the VIX "has pulled back too far too quickly, at least in the short-run, technically."

"The fact that the implied volatility has pulled back doesn't necessarily mean the worst is over," he warned.

CORRECTION: The UK vote to leave the European Union scared some investors and prompted them to buy volatility, Mark Newton, a technical analyst with Newton Advisors, recently told CNBC. Part of his explanation was misstated in an earlier version of this article.

CORRECTION: This version of the article also fixes grammatical errors and clarifies meaning in the second paragraph.