The Sum of False Fears

The CBOE Volatility Index, or “VIX” as it is better known, is getting a lot of attention in the financial press this week, as the markets reel from Donald Trump’s political and legal woes. But as I’ll explain, this so-called fear gauge is widely misunderstood.

The eight-year equities rally has the dubious distinction of being known as the least loved bull market in history, reflecting little faith in its fundamental underpinnings. And yet, until this week’s market rout, it enjoyed a low level of fear as measured by the VIX.

The tepid VIX reading had been cited as justification for ever-higher stock prices to come. The VIX has spiked in recent days, but only after touching a 24-year low earlier this month.

As traders increasingly bite their nails over political uncertainty, it’s important that you understand the precise nature of the VIX, so you can make portfolio decisions based on logic and not emotion.

The Chicago Board Options Exchange (CBOE) created the VIX as an indicator of the overall level of “implied volatility,” or fear in the stock market. It is based on the amount of trading activity in near-term put and call options on the S&P 500 Index. When demand for put options (which increase in value when the index declines in value) outweighs demand for calls, the VIX goes up. Likewise, when demand for call options (which increase in value when the index goes higher) outweighs demand for puts, the VIX drops back down.

The formula for calculating the VIX is complicated, but suffice to say there is always some level of implied volatility for the stock market since it never sits still. For that reason, a reading below 15 is dismissed as inconsequential. But once the VIX crosses above 15, many analysts take note because that reflects an unusually high volume of trading in index put options.

The thinking is, if a lot of investors believe the stock market is about to go down, then it probably will.

However, the historical evidence suggests this correlation rarely occurs. During the past year the VIX has risen above 15 on several occasions, each one a false alarm. In fact, the week before the U.S. presidential election, the VIX skyrocketed above 50, suggesting that a stock market correction was imminent. Just the opposite happened. More recently, the VIX jumped above 15 in mid-April, just before the S&P 500 gained a quick 5%.

The Merchants of Fear

The VIX doesn’t really work the way a lot of people assume it does. Most put option contracts on the S&P 500 Index are traded by professional portfolio managers, who use them as insurance to protect their portfolio values. However, the converse is not equally true. Since these investors already own huge stock positions, they don’t buy call options on the index when they believe the market will go up in value, because they need no “protection” against an upturn.

Most institutional money managers are particularly risk-averse, because the nature of the type of accounts they manage, such as pension funds, forces them to avoid big losses. For that reason, they tend to overreact to any event that might temporarily undermine the financial markets. They also tend to respond to unwelcome news by buying puts after the market has already started dropping in case a full-blown crash is forthcoming.

For all those reasons the VIX is an accurate measure of fear in the stock market — and not a good predictor of the future direction of the market.

However, that hasn’t stopped Wall Street from marketing the VIX to profit from investor fear. There are several exchange-traded funds (ETFs) and exchange-traded notes (ETNs) that track the VIX, allowing individual investors to bet on the people betting on the market. Over the long term, the VIX is a poor investment choice because it pays no dividends and can’t appreciate in value along the lines of an actual company, but over the short run it can deliver outsized returns.

In August 2015, the iPath S&P 500 Dynamic VIX ETN (XVZ) shot up from $25 to $33 in the week following China’s unexpected announcement that it was devaluing its currency. That gain of 32% occurred in a matter of days, but in the weeks that followed the XVZ gave all that gain back. From a longer term perspective, this fund’s share price peaked above $55 five years ago but now trades at less than half that level, while the SPDR S&P 500 ETF (SPY) has nearly doubled in value.

If my expectation for a stock market correction later this year proves correct, you will be hearing a lot more about the VIX in the months to come. But by the time the VIX has spiked enough in value to indicate that fear of a correction is high, it may be too late to do much about it.

My advice: pay attention to the VIX, but don’t let it determine when to take protective action. In future dispatches I’ll continue to place the VIX and other indicators into proper context, so you can trade according to objective data and not flawed assumptions.

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