The Price of Fear

The VIX is the price of fear. Short for ‘volatility index’, it measures expected future volatility in the market as implied by the price of a range of at the money index options (both calls and puts) on the S&P500. The index was first introduced in 1993 by the Chicago Board Options Exchange.

Implied volatility rises at times of extreme swings in the market, whichever way the market moves, because market makers adjust option prices to compensate for the extra risk they expect to run. The price of fear oscillates between measures the fear of being left behind in a rising market, or losing money in a falling one.

The VIX always used to trade between 10% and 20%, but in the credit crunch, life got a lot scarier. Recent changes in the VIX have been sizeable. When Lehman brothers went down, the VIX hit 90. Immediately thereafter there was a sharp upward move, on the back of the European sovereign debt crisis, which took the index to around the 45 mark, from where it declined fairly quickly to around 25. It now stands at 17.4.

Like most indices, the VIX has had babies. VIX-type indices are also calculated on the Nasdaq100 (the VXN, or ‘vixen’) and the Dow Jones Industrials (VXD). All of the indices tend to move in tandem to a greater or lesser degree.

An index has also been devised to chart the volatility of the FTSE100 index – the VFTSE – although at present most traders tend to follow the US VIX. This is for the very good reason that the UK and US stock markets are closely correlated, especially when markets are in meltdown mode. Backtesting of the UK version of the VIX seems to show a similar but less volatile movement in the UK index compared to the longer-established US one. There may not be enough data to draw of concrete conclusion from that.

Traditionally VIX readings above 30 suggest heightened uncertainty in the market: readings below 20 that mean the market is collectively taking an unduly relaxed view of life.

Some traders claim that the VIX’s recent low showed a ‘nothing can possibly go wrong’ mood of complacency, which in latter years has been frequently followed by a sharp rise in the VIX graph and a drop in the market. A ‘complacent’ reading on the VIX right now is also confirmed by a very low reading on the put-call ratio (see earlier article).

So is it time for a big short position in US equities? Beware. The jury is out, and the VIX takes no prisoners. It doesn’t always only peak conveniently when the market is about to fall sharply, or trough when the market’s about to tumble.

And the underlying tone in the US market is positive with a recovering economy despite poor jobs numbers, 2011 is traditionally a favourable point in the Presidential election cycle, and stocks are, if not excessively cheap, then not overly expensive either. A correction is possible, but it may not be a large one.

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