But, just how well does the VIX measure investor sentiment? More importantly, what relevance does it have to investors? We explore these things and more...
Part 1 - What is the VIX?The CBOE Volatility Index, or VIX, is a measure of the short-term expected volatility of the S&P 500 stock index. In simple terms, the VIX measures the likelihood that stocks of America’s largest companies will go up and down in value in the near future. The higher the VIX, the more likely it is that stock prices will fluctuate.
Part 2 - Is the VIX a good measure of investor sentiment or fear?
Mostly yes.
Using volatility to measure fear is one of those idiotic things that result when mathematicians attempt to measure human psychology. They do this by creating a model that is relevant most of the time, and assume that it is relevant all of the time.
The VIX makes the grossly inaccurate assumption, common in investing circles, that “volatility” and “risk” are the same. If you ask an average person what they are afraid of, they will not tell you that they are afraid their stocks will go up and down. What they are afraid of is that their stocks will go down and never come back up; that is, they are afraid of a permanent loss of capital.
Having said all that, investors often forget their beliefs and flip out when stocks temporarily drop in value. For practical purposes then, it can be said that while the VIX doesn’t measure what investors are truly afraid of, it does a reasonable job of measuring what they actually react to.
Part 3 - Does the VIX anticipate the future?
While some claim that the VIX anticipates the future, what it actually measures is today’s expectations of the future: so really, it measures the present. Expectations of the future change daily, and so does the VIX.
Part 4 – Is the VIX useful to options and futures users?
If you trade options or futures, it is vital to know the level of the VIX. Options that are far out-of-the-money increase in value only when the underlying stock gets close to the strike price. If volatility is high, the likelihood that your strike price will be reached is also higher. Thus, volatility tends to increase the price of options and futures.
A perfect example of the importance of the VIX occurred last March with UYG (a U.S. financials exchange traded fund), where I made one of the biggest investing mistakes of my life. U.S. financials had just hit a new low and everyone was talking about the end of capitalism, so I knew that financials would soon be going up. To capitalize on this, I bought UYG call options with a strike price of $40, at a time when the price of UYG was $15. And I waited.
Even as UYG climbed from $15 to $35, my call options hardly increased in value at all. The reason? Although the ETF was growing closer and closer to the strike price, the VIX was declining at the same time. My option prices hardly moved, and didn’t substantially increase in value until they hit the strike price. It is an important lesson to all those who would buy options during a time of market turmoil: be aware that during times of large market fluctuations, you will be paying a premium for your options. I would have been better off buying at-the-money options or UYG itself. It was a lost opportunity of regrettable magnitude.
Part 5 - Can the VIX be used to hedge my portfolio?
For those who run their own portfolios like a hedge fund, the VIX is tradable under the symbol “VIX,” and has a negative correlation to equities of about -.80. Reread that last line in case you missed it. VIX or VIX call options can therefore be bought in anticipation of disaster as an excellent hedging tool.
Conclusion
The VIX is vitally important if you buy options or futures, important if you want to hedge your portfolio, and useful if you want to put a number to how much gray hair you just got by watching CNBC. As a measure of investor psychology and market sentiment, however, the VIX has little predictive value: it mostly measures what just happened.
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Note to Journalists reading this blog: Please do me a favor and stop printing the headline, "VIX jumps as stocks fall." The VIX will always jump as stocks fall, since it is part of the calculation. It's like reporting, "Body falls as man jumps out window."
Thank you.
