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As many of you noticed, the volatility market was a little strange yesterday.  It was actually more strange early on and I was flooded with a bunch of emails asking what’s going on, but then stocks did finish negative at the end of the day which kind of spoiled the final numbers, but I still do want to explain it anyway.

Here was the action in both the S&P 500  (SPX)  and the VIX Index earlier on in the day:

 

Why are they both going up?  Why was the VIX up 11% at the same time that stocks were also up.  It’s happening again today.  Right now the S&P 500 is up 0.30% but the VIX is also up 6%.  What is going on?  Most people are used to seeing the VIX go down when stocks are up, which brings me to the topic of the day:

The VIX Index is non-directional.

It can and does sometimes go up when stocks are going up, and vice versa.  It’s true that the VIX index is inversely correlated to the S&P 500.  That is to say that when stocks go up the VIX tends to go down, and when stocks go down the VIX tends to go up.

 

The long-term correlation of VIX : S&P 500 is about -0.80

This means roughly 80% of the time these two indexes move in opposite directions.  So people aren’t wrong when they think it’s a little bit out of the ordinary to see the VIX go up so much when stocks are up as well.  However something I’m sure you’ve heard said before but it’s worth repeating is:

Correlation does not imply causation.

Neither one of them is causing the movements of the other.  The VIX Index is a statistical calculation based on S&P 500 options trading activity.  It’s not a predictive measure and it’s not particularly useful in determining what direction the S&P 500 is going to go.

 

The VIX Index only measures the forward implied magnitude of movement of the S&P 500, not direction.

I’ll get into some actual math behind the VIX tomorrow because many people don’t actually know what the VIX number means, but basically it’s just a + / – movement number, not a direction.

 

There’s no question the stock market is raging higher and some people may be tempted to call it exuberant.  I don’t know about irrational exuberance, but it’s definitely pushing hard to the upside.  This concept of the VIX Index being non-directional may actually come up a lot in the coming months / years.

The VIX is often called “the fear index” but there are times when it could also be called the “exuberance index” because again, it’s non-directional.  It could go up quite high even as stocks go up.

Here’s another example of a time in history where both the stock market and the VIX index were often times moving higher together.

For the 3 years leading up to the eventual dot.com crash you can see the VIX Index was averaging values in the mid 20’s.  This is almost never talked about, but the VIX index can and sometimes does spike upward when stocks are also moving higher.

 

Here’s some food for thought:

How would volatility products like the XIV have done during those final three years of the dot.com run up?  Stocks were raging higher so one might be inclined to say it would have done very well.

With stocks rising 33%, 28%, and 21% those three years, many would assume the XIV would have had fantastic years as well.

But with the VIX in the mid 20’s for those 3 years, would it have?

 

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