What Yesterday's Volatility Index (VIX) Spike Says About the Market Today

Yesterday (Thursday), the Volatility Index (VIX), which is often referred to as the "investor fear gauge," jumped 32.2%, its highest advance on the year and the index's biggest surge since April 2013.

The VIX spike was triggered by the downing of a Malaysian passenger plane on the Ukrainian-Russian border that killed 298 people, and an Israeli invasion of the Gaza Strip after ceasefire talks broke down. The global factors weighed heavily on investor sentiment and the VIX skyrocketed as a result.

There's a common misconception that the VIX measures stock market volatility. The VIX is really used to identify short-term market expectations through a complex formula that uses near- and next-term put and call options as its components, as opposed to an index like the S&P 500 that uses individual companies to derive its valuation.

When the markets grow, the VIX will generally shrink alongside positive investor sentiment and a growth in the major stock indexes. But in times of uncertainty, such as during a financial collapse or geopolitical turmoil, investors load up on option trading to bet on the market's downside. The VIX will then spike.

"As a contrarian indicator, the VIX usually has an inverse relationship with the markets," said Money Morning's Capital Wave Strategist Shah Gilani. "When the market is rallying the VIX tends to drop; when the market is tanking the VIX tends to rise. The scarier the broad market decline the higher the VIX tends to go - hence its reputation as the fear gauge."

The VIX's Historical Relationship with the S&P 500

Though there is no true statistical inverse correlation between the VIX and the S&P 500, in general the VIX will jump when the S&P 500 dives. The biggest VIX spikes, such as the 50% jump on August 8, 2011, are often accompanied with significant drops in the S&P, which dropped 6.7% on that same day.

And this is what happened yesterday. The S&P was down 1.2%, its biggest drop in three months and its sixth-biggest drop on the year, and the VIX had its biggest advance in 15 months.

The VIX stood at 14.54 when markets closed yesterday, which is still very low and is significantly lower than its highest close this year of 21.44 on February 3. Gilani said a reading greater than 30 is generally associated with elevated volatility and uncertainty, and a value below 20 signifies more confidence in the market.

When it's broken down, the 14.54 figure is a rough estimation of the annualized movement in the S&P 500. This current figure would thus estimate a market movement of 14.54% over the next year.

One important thing to understand about the VIX is that a big spike in this index is not a sign to flee the market.

"While a 'fear gauge' spike may not be something to fear, it is something you need to pay attention to," said Money Morning Executive Editor Bill Patalon. "In the near-term, this isn't a cause for concern."

In a newsletter, Bespoke Investment Group LLC called the jump "eye-watering," but further research from Bespoke showed that of the 21 other occurrences of the VIX surging ahead more than 30% in a day, the S&P saw an average "snapback" of 0.73% the next day. Additionally, it grows back an average of 0.77% on the week, drops 0.63% on the month, and sees a 1.23% increase over the next three months.

The S&P was up 0.74% by 1:30 p.m. EDT today (Friday), and the VIX was down about 17%. This could mean this was just a quick shot in the arm for an index that has seen pretty unexciting movements on the year.

"With a plane being shot down over the Ukraine, Israel launching a ground offensive into Gaza, and the White House being put on lockdown, it probably shouldn't come as much of a surprise that the long drought in volatility came to an abrupt end today," BeSpoke wrote in a newsletter yesterday.

The newsletter also noted that since 1990, in the 22 instances where the VIX has gained more than 30%, S&P's 1.2% drop yesterday was the smallest on record.

Investors and traders can profit from the movements in the VIX, though the VIX itself is not an investment vehicle. Rather, there are exchange-traded funds and exchange-traded notes linked to movements in the VIX that can act as the proper investment in stock market uncertainty.

These include the iPath S&P 500 VIX Short-Term Futures ETN (NYSE Arca: VXX) and the S&P 500 VIX Mid-Term Futures ETN (NYSE Arca: VXZ). The other options are leveraged inverse ETFs, such the ProShares UltraShort S&P 500 (NYSE Arca: SDS).

Yesterday, the VXX was up 9.8%, the VXZ was up 3.1%, and the SDS was up 2.3%, all of which are down today along with the VIX.

Tensions overseas may have only provided only enough fodder for a one-day surge in the VIX, but the events in Ukraine and the violence in the Gaza Strip could keep driving up the price of oil ...