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After VIX Spikes, Then Crashes, What’s Next?

Volatility has been the name of the game for Wall Street in the past five years. And as a result, the VIX — also known as the “fear index” — rose to great prominence, even among armchair investors.

But the VIX has collapsed over the past few years, and in January hit its lowest level since June 2007. Yes, we saw a brief spike last week amid the market mayhem, but the fear index has rolled back again to shed more than 10% in just a few market sessions.

You might be baffled at how volatility and uncertainty can define the market, but the VIX continues to push lower. Well, that’s because the VIX has rather complex rules and limitations.

For starters, a definition: The VIX is the ticker symbol for the Chicago Board Options Exchange Market Volatility Index, and shows the expected movement of the S&P over the next 30-day period based on options activity.

As such, it is not a conventional index of component stocks tied to actual price movements. That’s important to note.

It’s also important to note that the VIX historically has traded in a range of about 10 to 30. Right now it’s comparatively “low” around 15, but the spikes we saw during the Great Recession — and even more recently during the debt ceiling debate in 2011 — were outliers and significantly out of step with how the index typically behaves.

Furthermore, there are extended periods of time when the VIX remains rangebound and never moves significantly for months at a time. Those who think there is a clear inverse correlation between the S&P and the VIX are mistaken.

So where does that leave us in 2013?

Well, the VIX could very well move higher in the event of some bad news — bone-deep cuts related to sequestration or mayhem in Europe could cause the fear index to spike, as could unexpected headlines like last week’s Fed minutes. But take care not to think that comparatively low levels from 2009 mean the VIX is itching to move higher.

One final and important point: It is impossible to “buy the VIX” even if you did think there was guaranteed upside for the index. You can buy and sell VIX futures, which is what popular ETFs like the iPath S&P 500 VIX Short Term Futures TM ETN (NYSE:VXX) do. But this is a complicated game because you are buying futures on a futures index. Consider that from Wednesday to Thursday last week, the actual VIX index spiked a whopping 23%, but the VXX climbed only 10%.

All this is not to say you can’t make money trading the VIX. But be very careful of mean reversion as the fear index returns to pre-crisis patterns — and know the risks that come with “investing” in the VIX because your performance frequently is much different than the actual performance of the VIX on paper.

For my money, I’m not touching any VIX instruments. As we all know, an investment that crashed 50% in short order is only a value buy if it in fact moves higher again. Otherwise, you’re just buying into a painful downtrend that will eat away your cash.

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Jeff Reeves is the editor of InvestorPlace.com and the author of “The Frugal Investor’s Guide to Finding Great Stocks.” Write him at editor@investorplace.com or follow him on Twitter via @JeffReevesIP. As of this writing, he did not own a position in any of the stocks named here.

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