Yellow Light On The Street?

This long-watched volatility index is looking bearish.

Given record high oil prices, turmoil in Iraq, rising interest rates, and a closely fought U.S. Presidential election, you'd expect the stock market to be volatile -- subject to big, sudden movements. Yet the market is registering some of the lowest volatility readings in nearly 10 years, as measured by the Chicago Board Options Exchange (CBOE) Volatility Index, better known as the VIX.

The VIX, a long-watched sentiment indicator, is grounded not in the stock market but in the options market -- specifically, the options on the Standard & Poor's 500-stock index. Options traders bid up prices when they expect volatility to pick up, and pay less when they don't. The VIX is calculated using current options prices, and since options are short-lived instruments, the prices incorporate some expectation of market volatility. The current level is 15. (Go to cboe.com/micro/vix/historical.aspx for current and historical VIX data.)

The VIX tends to have an inverse correlation with the stock market: As stock prices rise and investor fear subsides, option prices, and the VIX, fall. At some point, complacency takes hold, making the stock market vulnerable to a sell-off. During market declines, the VIX usually rises. A rally can start when pessimism is rampant and no one feels good about stocks.

Now, the VIX may be signaling that the market is ripe for a fall. Since options prices are low, it's a good time to buy put options, or puts, for portfolio protection. (Puts rise in value when the underlying security falls; calls go up in value when the underlying security rises.)

Just look at VIX behavior over the last 6 to 12 months. The VIX has a tendency to hit a new low before the market falls and a new high ahead of a rally. For example, in March, May, and August of this year, low VIX levels preceded a fall in the S&P 500 of 5.5%, 3.3%, and 4.2%, respectively. Also in March, May, and August of this year, the VIX hit new highs, and there were rebounds in the S&P of 5.1%, 5.3%, and 6%.

NARROW RANGE

Some pros are wondering if the historic interpretation of the VIX is still valid. Has the market become less volatile, or are investors brushing off the economic and political risks? "There is a lot of unreasonable optimism in the market with the VIX as low as it is," says Chris Johnson, director of quantitative analysis at Schaeffer's Investment Research in Cincinnati.

Another way to put it is that investors are thinking that the market behavior in the future will be like the recent past. After all, even though there have been some sharp moves this year, the Dow Jones industrial average and the S&P 500 have been stuck in a narrow trading range. There's a another dynamic at work. With a go-nowhere market, many managers are selling call options to create extra income. That depresses the VIX as well.

As a result, some strategists think investors could be missing the S&P's warning light. "We could be in the first stage of a bear market, but no one believes it, so no one buys protection and the VIX remains low," says James Bittman, senior instructor at the CBOE Options Institute.

While it's too early to tell if a bear market is in the offing, Price Headley, chief analyst at BigTrends.com, an options site, sells stocks and buys puts when the VIX gets below 14, and buys stocks when it rises to 20. "It has been a great strategy for this year," he says.

Maybe the VIX will remain low, and nothing bad will happen. But a bit of portfolio protection at this point won't cost a lot, and it can ease your anxiety in these risky times.

By Toddi Gutner

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