I want to discuss why I use the trend in the VIX index as an indicator for downside risk.
When the VIX is trending higher, I interpret that as increasing downside risk for stocks. My reasoning is as follows.
I use the VIX Index as an indicator for real put demand. I say real demand, because traders buying and selling intraday is not what I’m looking for.
If VIX is trending higher, it signals to me that larger risk-taking market participants are hedging the downside.
When long puts, you’re also long volatility (demand for puts = long volatility demand).
When those market participants buy put options, market makers (not risk takers) selling those puts needs to hedge.
They do so by delta hedging, which is, in short, shorting the underlying security.
When volatility increase, the delta of an OTM option rise. This is logic: an OTM option is more likely to go in-the-money (ITM) when volatility is higher.
This is why you sometimes will see sharp sell-offs and market crashes: as the market starts to fall, market makers have to short more of the underlying to stay market neutral.
This is causing a self-reinforcing cycle.
So, when I watch the VIX intraday, I look out for the VIX trending higher. If so, the stock market is vulnerable.
If the VIX is trending down, as on Friday, I’m not anticipating a sharp sell-off into close.
Puts, Calls, Warrants - an area I hear about but have no idea on, who are the Market Makers and who are the risk takers ? In terms of remaining neutral, how are profits generated if participant remain neutral across the board ? So the VIX and SP500 are negatively correlated? is that right ?
farmerisland
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@gremic, it's more complex of an answer than just saying "Yes," but yes. Yes to the degree that VIX goes up as SPX crashes. Often VIX can be used as a predictive factor a little beforehand even, as this post is outlining.