Market Beat: The ‘Fear Index’
The “Fear Index” is a nickname that has been given to the volatility index or VIX. The reason it’s called the fear index is because it tends to rise in value when investors are nervous and worried about the stock market.
The volatility index value is derived from the implied volatility calculation of nearby options on the S&P 500 index. If the implied volatility is low, it means that options prices are relatively inexpensive. Options become inexpensive when there is not a lot of demand for them. When people rush to buy them for portfolio protection in times of crisis, the price can rise rapidly.
Currently, the VIX is at 9.81, which is very low by historical standards. It can spike fast if something spooks the market, like a natural disaster, a geopolitical event, or bad economic news.
In December of 2006, the VIX was all the way down to a reading of 8.60. The housing bubble burst and the fear index spiked to a high of 96.40 by October of 2008.
Investors, including large institutional investors, will purchase put options which drives up the prices of those options when they are nervous about the market. The historical volatility of the market affects the implied volatility, so options are expensive when the market is volatile and cheap when the volatility is low.
The market is at record-high levels now, and the volatility, both the historical and implied, is very low. That means that investors are both confident and complacent.
On a seasonal basis the VIX tends to bottom out this time of year, and spike in September or October. That’s just a seasonal average; it doesn’t mean that it happens that way every year.
Stock market corrections are defined as drops of at least 10 percent, and are common in bull markets. Bear markets are defined as declines of at least 20 percent that last a minimum of six months. Presently, we’ve been in a long bull run without a meaningful correction.
The stock market spends most of the time rising with falling volatility. On average, it spends approximately 85 percent of the time rising. The remaining 15 percent of the time we see falling prices accompanied by rising volatility.
Volatility funds and options can be good hedging tools for portfolio protection in times of uncertainty.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at http://www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.