Understanding the Volatility Index

“The stock market is a summary of people’s views about the future.” This statement was made by Glenn Hubbard in The Wall Street Journal, October 28, 1997, and we are surely seeing illustrations of this on a daily basis now. When the latest job loss report comes out, the market responds by dropping; the stultifying information on declining home prices or a negative GDP growth triggers another elevator ride — downward – in the DOW and S&P. When the price of oil and, correspondingly gasoline, starts sneaking upward, the market quakes and rising food prices broadcast loudly on nationwide TV bring on another convulsion.

How long can investors withstand this negative pounding day by day? If you pore over market reports and watch the indexes careening up and down, you’re bound for the psychiatrist’s couch or a heart attack. Consider this statement, “Volatility is more a function of what’s reported in the media than the actual fundamentals of companies and economics. And this is precisely what creates the opportunity for profit,” written by Steven Selengut, investment manager and founder of Sanco Services, in his 1999 book, A Millionaire’s Secret Investment Strategy.

During the Fall of 2008, major financial markets lost more than 30% of their value and this period was one of the most horrific in US financial history. Experts cite this time as a lesson of what can happen when rational thinking gives way to irrationality. The frantic growth of the subprime mortgage market and the development of irresponsible investment vehicles to back them fueled the fire. This, combined with explosive consumer debt, contributed to the financial turmoil.

Understanding the VIX

The Volatility Index, the VIX, is one of the investment industry’s most widely accepted methods to gauge stock market volatility. It is an effective measure of investor confidence or lack of confidence in the overall market and economic conditions. The VIX uses a wide range of strike prices of various puts and calls that are all based on the S&P 500. It does not measure the volatility of a single issue or option instrument. By incorporating a wide range of S&P Index options, it provides a good cross-section of investor sentiment and market expectation of near-term volatility.

The VIX has an inverse relationship with the market, meaning that a low VIX, within a range of 20 to 25, indicates that traders are more disinterested in the market. This may develop into a rising VIX because the market is fearful and concerned about its future direction. When the market again gains confidence about its direction, the Volatility Index heads downward. A rising stock market is seen as less risky while a declining market is viewed with increasing fear. As the market becomes fearful, the VIX rises.

Effects of the VIX

The greater the perceived risk in stocks, the higher the implied volatility. As this happens, the expenses associated with options, especially puts, also increases. Looked at this way, the implied volatility is not really about price swings but is due to the implied risk that is associated with the market. As the market declines, the demand for puts increases. This increased demand means higher prices for puts and, again, higher implied volatility.

The VIX is one of the most widely accepted ways of gauging stock market volatility. This “Fear Index” is a good measurement of investor sentiment but it is also helpful in identifying an impending market bottom. It is rarely out of step and can help investors see the bottom forming and the development of a new, stronger, bull market.

Michael Doran is Managing Director of the long/short equity fund, Emerald Bay Partners LP. Mr. Doran can be reached at (530) 677-1635 or info@sierrainvestor.com.