This week’s trading was the most challenging it’s been in a while, with the major market indexes witnessing an uncharacteristic increase in volatility.

Rather than run from volatility, you must embrace the fact that these are the moments that are going to test you and make you a better trader.

Given the importance of this shift in markets, I spent a lot of time on the Master’s Club video lesson this past Tuesday explaining to members what the market’s fear gauge, the Cboe Volatility Index (VIX), has been warning of and how to position for it.

As traders, we simply can’t expect that it’s always going to be smooth sailing for the market, even as the Fed continues to provide historic levels of liquidity.

That’s why it is so important to always have one eye on the VIX, and today I am going to go deeper into what you need to look out for.

Some VIX signals are more important than others 

At its core, the VIX is used by market participants to hedge equity portfolios against a downturn in the market.

It is important to understand that the VIX is measuring the S&P 500 cash index’s (SPX) implied volatility over the next 30 days, through the use of SPX options. 

We talk about implied volatility a lot when discussing options since this is a key measure that goes into the pricing of options contracts.

Without getting too technical, just understand that the VIX is measuring the theoretical volatility of the S&P 500 several months ahead, as opposed to the volatility that has already occurred, also known as realized or historic volatility.

Once you grasp this concept, you then begin to see the importance of upward movement in the VIX, because this is telling savvy traders that the market’s level of fear is rising.

But some upward swings in the VIX are more concerning than others.

On the chart I am about to show you, I’ve placed the S&P 500 in the top panel and the VIX in the bottom panel.

What I want you to focus on is the fact that most of the large pullbacks in the S&P 500 have occurred after a VIX divergence, where the VIX is no longer making new lows as the S&P 500 is making new highs.

Figure 1

So what’s going on at these points in the market?

Why are these divergences important?

Remember, the VIX is the market’s fear gauge, as it measures what investors feel about potential risks to the S&P 500.

So when the VIX is falling, that’s telling us that investors don’t see a lot of stress for the market in the next 30 days.

But, when we start to see the VIX turning higher and forming a base against the S&P 500 as it is making new highs, that’s telling us the market is anticipating trouble ahead.

Don’t forget, there’s a lot of very smart people that make up the market, and their collective thoughts typically become evident in tools like the VIX, providing good trading signals ahead of time.

As you can see at the extreme right-hand side of the chart, this collective hedging of equity portfolio risk was showing up again in the VIX earlier this month, when it was no longer making lower lows as the S&P 500 was making new all-time highs.

As I discussed in the Master Club, what I think we are witnessing here is not the start of a large market crash, but rather the market simply taking a breather after front running the year-end Santa Claus rally.

As Figure 2 shows, the action we’ve seen so far in November is par for the course, and it’s something I’ve alerted Total Alpha members to prior to the runup.

Figure 2

Specifically, this chart shows the average performance of the S&P 500 over the past 20 year broken down by month.

As I’ve highlighted, November is notorious for starting out very strong, before struggling mid-month in advance of another late-month surge.

Bottom Line

Once again, the market’s fear gauge has done its job of warning market participants of an increased level of nervousness at the November highs.

If history repeats itself as it often does, however, this weakness we are witnessing now should be part of a pause that refreshes the market and attracts new buys for another run to new highs later this month.