Can You Use VIX Index To Gauge When The Market Will Bottom?

Has the market bottomed yet? Every now and then, we will see articles or videos about whether the market has bottomed and one of the tools that is commonly spoken about is the VIX index! It seems that some investors believe that we can use the VIX alone to gauge if the market has bottomed.

How useful or reliable is the VIX index in helping us to make our investing call?

What is the VIX index & how does it work?

The VIX Index measures the 30-day expected volatility of the U.S. stock market. The calculation for the index is derived based on the call and put options prices of the S&P 500 index.

In layman’s terms, the VIX index can be seen as a way to gauge the general market sentiments and the level of fear among the overall market participants. This is why the VIX index is also commonly being referred to as the fear index.

To understand how the VIX index works, we need to first understand the impact of psychology of the market participants on the stock market itself. When market participants are fearful about the uncertainties and the outlook of the stock market, there tends to be more selling pressure. They are fearful of holding on to the equities which also translates to lower demand for equities. Hence, this pushes down the stock market prices.

Since the VIX index gives us a gauge of the level of fear, we can see that the VIX index moves in the opposite direction as the S&P 500. When the market is getting fearful, prices of VIX increase while prices of the S&P 500 decline.

S&P 500 vs VIX index price chart

More examples of VIX vs S&P 500

During March 2020, the VIX index shot up to an all time high of early 80s while the S&P 500 prices plummeted.

If we look at even more recent examples, the VIX index went above the 30s level with the Fed raising interest rates and the Russia-Ukraine war narratives while the S&P 500 went into a correction (as at 10 June).

What’s the point of looking at the VIX if it merely just moves in the opposite direction from the S&P 500?

Historically, when VIX shoots up above 30 level, it is usually an indication of extreme fear and turbulence in the markets and it is usually a turning point for the stock markets. In other words, once VIX hits above 30 level, we can usually expect that the VIX will come down from the peak while the S&P 500 prices will start to go back up from the low.

Source: spglobal.com

The good news is that based on historical data, on average, the markets generally deliver a double digit forward return when VIX hits above the 30 level mark.

VIX need not spike to a new high for market to bottom

With the VIX index hitting somewhere above the 30 level mark a few times in 2022, a good majority of people believe that we are not near the market bottom yet as the VIX has not spiked to a new high like what we saw during the COVID crash.

Does VIX really have to spike to a new high for us to see the market bottoming? Let’s check out some previous examples.

Take a look at August 2015. The VIX spiked up to the 50 level mark. We might think that this should be the bottom for S&P 500, but just a few months later in January and February 2016, the S&P 500 formed an even lower low. Interestingly, the VIX index did not spike to an even higher level! But this was actually the bottom and the S&P 500 rallied up all the way till the end of 2017.

Another example.

In early 2018, there was a market correction. The VIX index spiked, and even went above the 40 mark during the day itself. However, this was actually just a correction of less than 15% in the stock markets. Then, prices started to hover a bit before finally returning back to the previous high in 2018 and shortly after in end 2018, S&P 500 prices came down again.

In fact, the market pullback this time round was deeper than that in early 2018. But did the VIX spike to a new high? The answer was no! The peak for VIX in end 2018 was lower than the peak we saw in early 2018.

From these examples, we can clearly see that the VIX index does not necessarily have to spike to a new high for the market to bottom. The conventional wisdom that VIX has to spike in a market bottom does not hold water.

Join our Telegram Channel to stay in the know with our investing insights.

VIX index should not be used in isolation

While VIX can be useful to help us gauge the market sentiment (whether generally investors are greedy or fearful), it has its limitations in terms of timing our investment entries.

Hence, we do not just use the VIX index in isolation when looking out for possible market bottoming. We would want to always use varying sources of information or facts together to form a more comprehensive analysis of the markets.

One piece of information we look at is the percentage of stocks on the S&P 500 which are currently traded above the 50 day moving average. Historically, when this percentage goes below 20%, it is usually at a very oversold territory and chances of a rebound in the stock market gets higher.

Now, you may ask. There are a few years where this percentage plunged down to a single digit, so does that have to happen before we are near a market bottom? Not necessarily true. Well, over the last 20 years, this has mostly happened during the bear markets such as the COVID crash, the financial crisis.

Other sources of information which we and our students use to analyze market bottom include market maker analysis to see if there is reasonable manipulation in play. And also our proprietary manner of technical analysis of the financial markets which are other topics altogether. Over the years, they have been pretty useful. By and large we have been fairly accurate and for those who are in our public telegram channel, you would have known that we entered huge positions in the China market in the middle of March and in the US markets in early May. Whether they are the absolute bottom for now, time will tell. We may be right, we may be wrong, but it doesn’t matter. What matters is that we are absolutely sure those were fantastic prices to lock in for the years to come on the good stocks that we bought.

Concluding thoughts

Contrary to popular belief, the VIX index does not necessarily have to spike to a new high before the market bottoms. Most importantly, never use an indicator such as the VIX index in isolation because there is no one indicator which is completely foolproof. Have on hand various sources of information to make more informed analysis of the markets.

If you want to learn more on how you can analyse the markets using various tools, you may check out our upcoming workshops here.