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A simple prespective look of VIX - Trading Journal (12.3.20)

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Often times business news brings up a phrase called "fear index" when talking about the VIX. In general a VIX higher than 20 will mean there is "fear" in the market. Fear in that investors are willing to pay higher premium to own insurance from a market crash, or specifically index SPY crash.

Recently this year the volatility has been dramatic. SPY had more than +20% draw down while also over +20% recovery making it a year that was a bear market and now a bull market. In that time period the VIX started out in the low teens that lead up to triple digits in late March and ended up now back in the low 20s. A big roundabout move in less than one year.

The VIX is currently in position to fill a gap that broke out in March and one thing always hold true to VIX is that all gaps up or down will get filled sooner rather than later.

The focus here though is why the current bull strong market exists when so many worrisome headlines continue to be discussed in the real economy. The VIX has a lot to do with this. You see the VIX prior to the US elections was bought up to the point of very elevated levels, it got up to the 40s several times after its trip up to triple digits in March but never really subsided. Then right after the elections the VIX immediately rapidly falling down from low 40s to where it is at now low 20s. In the mean time the drop in VIX as lifted the market upward and on top of that people who were on the sidelines uncertain to invest had a clearer picture as to the future and started pushing the buy buttons.

The real reason the current bull market is so strong is the fact that most investors who had bought insurance for a crash have to now close out their positions. In order to close out their positions they have to buy back the shares of the stock they had originally put on and the VIX is an indicator showing the drop. As the year is coming to a close those who have bought insurance were likely buying it just for the year 2020 therefore if they did not close the insurance they would expire worthless.

The anticipation of a bad outcome or expecting something bad to happen that would lead to a market crash is consider the wall of worries. When too many traders are on one side of the trade they will revert back to mean and then some in dramatic fashion. The Nov. election outcome was the turning point of this year's wall of worries. There are still a lot of headwinds against the market but due to all the premium in VIX it has been the source of the support bulls needed to buy every single market dip since March lows.

The wall of worries will always be there, but how high or significant the events will be the cause people to buy up more insurance. This year there were many events that led to higher bids on insurance. Whether it was covid or the election people paid a lot for the uncertainty. This goes to show that the VIX is showing expectations of future fears. In the long run fear subsides and markets continue to rise, it has done so for over 100 years. The just of it is just because the VIX is high does not mean the markets will certainly fall. On the contrary as what we have seen in the past couple of months it has help life markets as the high VIX has fallen.

One other key point I like to make is that expecting a VIX to rise is some of the indicators traders look at to anticipate of a increase volatile market. When the VIX rises maybe able to gauge but it is worth noting that events that are known as apart of the wall of worries tend to already built into the VIX. That is because the events that make up the wall of worries are known and traders have loaded up on hedges to protect themselves. This coincides with a higher VIX. In order for the VIX to rise there has to be an unknown event creating the fear, with out it the markets generally revert back to being calm and prices generally rise. The next time you wonder why fear in the markets do not rise when there are so much worries in the real economy, take note that the worries are known so participants in the market effectively have hedges in place. When the worries do not pan out the hedges are removed. The hedges act as a support to the markets because traders have to buy back the shares they hold in anticipation for a fall.

This is very much physiological than technical. The higher the VIX the more likely in the future there will be a point where price has to climb to due the fact that the holder of the insurance has to buy back shares sooner than later. When they capitulate it will have dramatic moves not in their favor. Current bull market in SPY and other indexes is proving this point.

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