Investing Using Stock Market Volatility - Does It Work?

Yesterday saw a terrific relief rally and a decline in stock market volatility. It marked the best day in over a year. The CBOE Volatility Index - stock market symbol VIX - measures stock market volatility. Throughout today stock market volatility declined and the VIX index stayed below 20.00. I had a number of emails from readers wondering why I was still holding my remaining 10 SPY puts after yesterday's big rally and with the VIX moving lower yesterday and again today.

While the VIX index is obviously good at showing stock market volatility, how good is the VIX Index at predicting market direction, up or down? For those investors who follow the volatility theory for getting into the market and out of the market as explained in the article Understanding The VIX, this move back below 20.00 would seem to indicate that there should not be a lot of concern and therefore no need to hold SPY puts.

But is this very accurate? The chart below shows the VIX Index since January 2011. Since June the VIX Index climbed to a high of 24.65 but note how it never came close to the highs of mid-March when the stock market volatility index reached as high as 31.28. Overall despite the weakness from May which has seen a fairly strong correction, the market volatility has stayed surprisingly low. But is this just investors' complacency? While many analysts have called the recent correction as an end to this bull market, the majority of investors seem to be within the bulls camp, or certainly that appears to be what the VIX Index is indicating.

To decide how good the VIX Index is at predicting market direction, I spent a bit of time looking back at past stock market volatility during 2007, 2008 and 2009 to see if, as an investor, I can rely on the VIX Index with my investing.

Stock Market Volatility Chart - June 2007 to October 2007

Below is the chart for the period of June 2007 to October 2007. Note how in mid-August the VIX Index was above 30 and then gradually pulled back until by Mid-September to October 2007 the VIX Index was below 20.00. Would this have been a good time to go back into the market as the VIX Investing Theory indicates?

Let's check the next chart below. This chart shows the S&P 500 from Mid September to Mid November 2007. As many investors may remember, the fall of 2007 was not the best of times. So when the VIX Index indicated that stock market volatility was declining below 20.00 the market did indeed rise but within two weeks a decline commenced which by mid November left the market down about 150 points or 10%.

Stock Market Volatility - 2008

Here is the VIX Index chart for 2008 during the summer. In July 2008 the VIX Index moved above 30.00 and then commenced a pullback that lasted throughout the rest of the summer and then fell back below 20.00 by the end of August. This should have according to the VIX Index theory, signaled that the market trend was changing to move back up. The next chart shows what happened.

Here is the S&P 500 chart for the end of August 2008 to Mid October 2008. During this time period the S&P 500 lost 400 points or 30%. So while the Stock Market Volatility may have declined through the summer, it was again a false signal that it was again safe to go back into stocks.

Stock Market Volatility Chart - 2009

One last chart worth looking at is the VIX Index for the period after the March 2009 collapse and the run up in stocks. The VIX Index measured stock market volatility at a high of almost 50.00 on March 9th 2009 and fell to just below 30.00 by mid-June 2009. The VIX Chart theory says anything over 20 marks a period when an investor should stay out of the market, while below 20.00 marks a time to re-enter.

The S&P 500 during this time period rallied from the lows of March 9th 2009 over 270 points or 40% by mid-June 2009. The VIX Index theory would have kept investors out of this incredible rally.

SUMMARY

Many analysts feel the recent bull market ended in May. This would make this bull market one of the shortest on record. The recent strong run up, sell off and bounce back is not really increasing volatility, as you can see in the VIX Index chart at the top of this article.

However the whipsawing is actually not a good sign for the market which is why based on my past years of being in the market and seeing this whipsawing, leads me to keep my spy puts in tact at this time. Looking at the above charts proves to me that I cannot use volatility in the stock market as a trading mechanism. But I do think it is important to keep an eye on the VIX Index to be aware of investor sentiment.

But right now I believe the market is sitting at a crossroad with no clear direction either way and as we have seen in the past, a decline in stock market volatility right now does not guarantee the market is not going to pullback harder than investors are prepared for.