Fear and greed are the most important factors in the market. When the markets are going up, traders tend to be greedy and buy more with the hopes that the upward trend will continue. When the price of an asset is moving lower, traders tend to short, with the hopes that the price will continue declining. Fear on the other hand leads to many investors to exit their trades. It is because of these reasons that you see large spikes whenever a major news crosses the wires. For example, if there is a crisis in the Middle East, the price of crude tends to spike, even when the investors don’t know for sure whether this will affect the supply of the commodity.
The challenge for investors is on how to predict the future uncertainties. One of the most popular ways to do it is the use of the VIX index. The VIX, also known as the fear index, is one of the most followed financial derivative in the market. The index was designed by Robert Whaley in 1992 under the authorization of the Chicago Board of Options Exchange (CBOE). The index was then tweaked in early 2000s.
The inputs of the index are the call and put options on the S&P 500 for the near-term options with more than 23-days of expiration. The next-term options have less than 37 days if expiration. It also takes input from the risk-free US treasury bill interest rates. The goal of the VIX is to predict the implied volatility of the S&P 500 in the next 30 days. Call option is an option to buy a security at an agreed price on or before a particular date. The put option is the opposite of call and is the option to sell at a future date.
In the past two weeks, the VIX index rose sharply after Donald Trump added tariffs to Chinese goods. This week, it rose after China announced retaliatory tariffs. In the past few days, the index has eased a bit as the trade fears ease. This is because investors expect Donald Trump and Xi Jinping talks to be productive in Japan at the G20 summit.
On the chart below, the VIX index has declined below the 45-day and 25-day moving averages. At the same time, the RSI has dropped from a high of above 77 and declined to the oversold level of 30. In the short term, the pair will likely continue moving lower to the low of 15.