It’s a long time since Market Maven has looked into volatility trading and the fear index, so I’ll start off with a few words about what it is, and why it’s so exciting at the moment.

The real name of the “fear index” is the CBOE Market Volatility Index, but it’s usually referred to by its ticker symbol: VIX.

The VIX was first established in 1993, and it is calculated on a weighted blend of prices for a range of options on the S&P calls and puts. The method of calculation isn’t too important to us – we simply need to understand that, in essence, it is a gauge of investors’ confidence in the market.

Why am I talking about volatility trading today?

The VIX, in general, has an inverse relationship to the market. The VIX goes up as stocks decline, and the VIX declines as stocks advance. A low VIX means that traders are confident about market conditions. A high VIX means that they are fearful.

A rising market is inherently viewed as less risky, while declining stocks tend to go hand in hand with volatility.

Last week, the VIX hit a 3-year low, as the S&P jumped to a 2-year high.

Low fear levels and rising equity prices – sounds good, doesn’t it?

So, does that mean that we can put our feet up, relax, and watch the market continue upwards?

Unfortunately, the fear index doesn’t work like that.

Let me remind you of what Warren Buffet said: “Be fearful when others are greedy, and be greedy when others are fearful.”

And let me rewrite that slightly (apologies to Mr Buffet): “Be fearful when others are complacent.”

So, if the VIX is saying that investors are complacent – that’s exactly when we should be watching our backs!

The last two times that the VIX was at these kind of levels were in April last year, just before the European debt crisis hit home, and back in 2007, just ahead of the sub-prime crash.

Therefore, to the contrarian investor, a low VIX reading is considered bearish.

What that means for equities

The S&P has now clocked up seven winning weeks in a row – it hasn’t had a run like this for four years!

So it wouldn’t be unreasonable to expect a correction.

Take a look at the chart below which was posted by Price Headley on Seeking Alpha

Here we can see the S&P at the top, pushing against its 50-day Bollinger band (the red line). Meanwhile, the VIX is breaking its 30-day Bollinger (the green one).

The set-up is telling us that both prices could bounce off these bands – the VIX upwards, and the S&P downwards.

I, for one, will be closely watching the VIX levels for signs of an upward spike, which may be the signal for a correction in the equities markets.

And, remember – when fear hits, investors usually run to the safe-haven of the US dollar.