A slightly deeper understanding of the VIX and what is going on under the hood of the stock market indices can help traders focus on what makes money rather than what makes headlines.

In this post I clarify what the VIX is and what it really tells us and what traders can focus on to improve their results.

What is the VIX?

You may have heard of the VIX. You certainly will have if you were following the stock markets in 2008/2009. The VIX is heralded in the financial media as the market’s “fear gauge”.

For anyone not familiar with the VIX, it is the most followed barometer of the market’s expectation of volatility over the next 30 days.

Stock market volatility has an inverse relationship with price. When the market falls, volatility – and the VIX – rises.

This inverse relationship is how the VIX became the market’s de-facto gauge of fear and risk.

An important thing to remember about the VIX is that it is a coincident indicator, which means it only tells us what IS happening. It is not a predictive or leading indicator. Spikes in the VIX only occur as the market is actually falling – they do not forewarn of a future fall.

During 2008/09, spikes in the VIX, record highs in the VIX etc. were almost daily headlines. To be fair, during the crisis and in the period immediately following, the VIX did a solid job of highlighting periods of heightened stress in the market.

Then and now

Things have shifted a little since then.

What characterized The period from 2008 until 2013 was “risk on/risk off” behavior. Correlations were high (stocks all moved up and down all together). And whether the market was in risk-seeking or risk-avoiding mode was determined mostly by macroeconomic events (think Greek bailouts, Fed meetings and the eurozone crises).

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The situation we find ourselves in currently is more usual. Correlations are lower – some stocks can fall even as most are rising. Money is flowing from one sector or group of stocks to another as investors allocate capital based on what they think will be the next group of stocks to outperform.

But what we continue to see is a raft of articles citing “market complacency” or the market “doesn’t care” about risk. The VIX is “too low” and so “volatility” simply must increase…or so the story goes.

A better interpretation and my theory

At this point, a more accurate definition of the VIX is in order. Then I will introduce my theory on what is really going in under the hood.

So back to the VIX. As I mentioned above, the conventional way to interpret the VIX is as a “fear gauge”.

But in reality, all the VIX does is measure investors’ willingness to hedge. When the big market players – hedge funds in particular – buy put options, this props up the VIX.

Usually, even in stock market uptrend, the VIX will exhibit some volatility because funds are hedging. They are buying put options to insure some of their equity exposure or lock-in some profits.

Sector rotation is the new VIX

Right now, there aren’t a lot of people hedging with put options. Why? Because they are doing something else.

Enter “sector rotation“. What funds are doing now consistently is employing an aggressive type of sector rotation strategy.

This is all fact. This is what is going on under the hood. Investors used to following nothing but index-tracking ETFs need to get their eyes off the S&P 500 and focus a little more on the market nuances.

My theory on the reason for this change in behavior has to do with the rise of ETFs. You see, ETFs and passive index funds have seen a torrent of money flow into them over the past 10 years. A lot of this money has come from active managers – those funds that charge a fee for attempting to beat the index. Active managers and hedge funds have (mostly deservedly) received a great deal of criticism for charging high fees and delivering sub-market performance…and the investing public has voted with its wallet!

ETF active passive

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In order to justify their fees and keep investors’ money, active funds need to deliver performance superior to market indices – they need to deliver what the industry calls alpha. To beat the indices, they have to pick stocks that outperform. So the strategy they are employing is aggressive switching from one sector to another in an attempt to capture this elusive out-performance.

However, they can only trade in the biggest, most liquid stocks in each sector. This is why the largest market cap stock in each sector has significantly outperformed the S&P 500 this year. You can see how this creates a self-fulfilling prophecy – where to beat the indices the funds all have to buy the same small number of high-flying stocks.

This leads to another “however”. Most funds have concentration limits on their portfolios which prohibit them from investing more than a certain percentage of their portfolio in one stock. This concentrated buying pushes these few high-flying stocks up. This in turn causes those stocks to breach concentration limits which means the funds then have to start reducing their exposure to them. This is exactly what we have been witnessing in the tech sector recently – heavy rotation out of a sector that has performed very strongly all year.

The net result is we are not seeing any market corrections. We are instead seeing position corrections – and to a lesser extent sector corrections – within the market indices.

What Can Individual Traders Do?

I avoid getting caught up in this by focusing on high probability setups I find in smaller stocks within each sector.

I’m not trying to beat an index to justify outrageous fees. I’m simply trying to make four figures a week by trading stocks. Therefore, I don’t have to own FANG stocks or NFLX or the like. Instead I can focus on the best setups I find in smaller stocks that are not on the radar screens of the big funds.

The stocks I trade are usually still in the multi-billion dollar market cap range but they often aren’t the very largest stocks in a sector. Mostly these stocks don’t make the headlines. But mostly I do make money on them. I am able to avoid some of the big sell-offs and higher volatility some of the high-flying large cap-stocks encounter.

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Good Trading!

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