Don’t Fear The “Fear Index”
The name CBOE Volatility Index may not ring a bell for you because it’s more commonly known by another name. Chances are, if you participate in the stock market, you have heard of the VIX. It’s hard not to.
Every time the market hits a rough patch, the finance news headlines will say the VIX rose by this much and that much.
The reason we care about the VIX is that it is a measure of implied volatility and reflects market sentiment. When market angst is high, VIX rises. For that reason the VIX is also known as the “fear index.”
The VIX in Recent Years
Take a look at the chart, which shows a three-year chart of the VIX. The smaller spike that started in early 2018 corresponds to the trade war saga between the U.S. and China. The fluctuations between 2018 and 2020 largely reflected the market’s interpretation of how the drama was playing out.
Before the coronavirus changed the world, it was the drama between the U.S. and China that most impacted the market. And the large spike in 2020? That’s when the stock market realized the severity of the COVID-19 outbreak. The market recovered swiftly so it may feel like ancient history, but back in early 2020 the S&P 500 suffered its fastest fall into bear territory on record. The widespread lockdowns were unprecedented and no one knew what was going to happen. It makes sense that the VIX soared.
How Is It Measured?
Indexes track something, and the VIX is no exception.
The VIX is linked to the S&P 500, the stock index generally regarded as a proxy for the U.S. stock market. But instead of tracking the S&P 500 itself, the VIX tracks the options on the S&P 500.
At its core, an option is a bet on the future price direction of a security. If you think the S&P 500 will be higher by a certain date, you buy a call. If you think it will be lower, you buy a put. (The opposite is true if you are writing an option instead of buying.)
When option buyers expect high volatility, they are willing to pay a higher premium because there’s a better chance of high profitability. Conversely, when option writers (sellers) expect high volatility, they wouldn’t be willing to write an option unless they get a high premium for the higher risk.
Consequently, by following the premium movements, you could get a sense of market sentiment. When the VIX jumps, it’s usually because institutional investors (the so-called “smart money”) are buying a lot of puts to protect their long positions.
The VIX tracks the S&P 500 option prices, including monthly and weekly options, that are set to expire in between 23 days and 37 days. The data is put into a complex formula to derive an index value.
How complex is it?
CBOE provides step-by-step instructions on to calculate the VIX. It takes up six pages in the PDF file. It would take hours to calculate by hand. Thankfully, CBOE does that for us.
Make Use of the Information
VIX values north of 30 are generally considered to suggest higher volatility resulting from increased investor uncertainty and fear. On the other hand, VIX values below 20 usually imply good times for the stock market as investors are not particularly worried.
The VIX can offer you insights into how the market is feeling and help you make trading decisions in short term. And if you prefer to invest for the long term, the VIX can also give you some contrarian signals. As Warren Buffett famously said: “Be fearful when others are greedy and greedy when others are fearful.”
Look again at the 2020 spike in the chart above. The only other time in history the VIX has ever gotten that high was during the 2008 financial crisis when it looked like capitalism might collapse. It signaled that the market was extremely bearish. If you had bought when others were running for the sidelines, you probably did quite well.
As with everything else in investing, you shouldn’t only rely on the VIX to make your decisions, but it’s a valuable tool to keep in your arsenal.
Editor’s Note: The combination of rapid economic growth and rising inflation is roiling the VIX, aka “fear gauge.” These conditions add up to a boom in commodities. The world is clamoring for vital raw materials, such as copper, zinc, lithium, and rare earth minerals. As the economic recovery accelerates in 2021, these commodities should continue soaring in price. Commodities also serve as time-proven inflation hedges.
We’re especially keen on the economically sensitive raw material of copper. For our favorite copper mining play, click here now.