testing out the crystal ball called VIX

Definition of VIX from investopedia:

The ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk and is often referred to as the “investor fear gauge”.

I started to get interested in VIX because I see how the market is moved by aggregate of human emotion: greed or fear. I was looking for an index that quantify those emotions.

As I learned about this index, I discovered that there’s an inverse relationship between the VIX and the S&P 500. What’s more interesting is that the VIX shows what the market participants expect, so it’s a forward-looking indicator. A crystal ball. (Learn more from the video near the bottom of this CNBC article).

This chart shows 2 years data of the VIX (blue), with EMA 50 to smooth out the short term volatility(brown) compared to the SDS (2x inverse of the S&P 500). Obviously, this is not 100% accurate as you can see in the divergence between mid mar to july 2007, but for the most part the two have are very similar.

Today I bought some SSO(24.83 +1.28 +5.44%, ) to test this out since in the past week the VIX has been dropping, so if this strategy is valid, the S&P 500 will continue to rally in the next week until Tuesday.

I believe this strategy has some validity since human beings adjust our actions depending on our expectations.