Trading and investing in stocks means being clear-eyed about risk. But there are market indicators to help you judge what to worry about, and what sectors look most exposed.
The VIX is shorthand for the Chicago Board Options Exchange’s (CBOE) volatility index. It’s based on the US S&P 500, the index of America’s biggest public companies, and designed to measure anticipated market volatility. Note ‘anticipated’ or ‘perceived’, not ‘actual’.
What does the VIX do?
The VIX looks at near-term volatility based on calculations from options data of where markets may go in the next 30 days. It’s quoted as a percentage rather than money.
Try not to think of it as a ‘bear’ index. The VIX looks at negative and positive sentiment, political noise plus other market patterns and inputs.
A high VIX reading – traditionally any score below 20 is considered low – may indicate concern about market risk, either up or down. A high VIX reading means more option buying is going on, giving a buyer a right to sell off a security at a certain time for a certain price.
In other words, it’s closely tracking volatility. Keep in mind, a VIX reading is not about stock prices; it’s about S&P 500 option prices. It’s about sentiment. It never tries to lead.
And it works…how?
The computational VIX technicalities are arcane. In the CBOE’s own words, “VIX is a measure of expected volatility calculated as 100 times the square root of the expected 30-day variance (var) of the S&P 500 rate of return. The variance is annualized and VIX expresses volatility in percentage points.”
Got that? Hmmn. More talk of “risk-neutral expectation of variance” follows. So let’s keep it short: a VIX reading is a blended read-out of insurance put and call options of how traders think the market may respond in the near future.
Now let’s look at VIX readings for the first quarter of 2017: in January a TV gameshow host and real estate speculator elbows his way into the White House following a tumultuous election result.
In February the risk of a far-right populist presidential victory in France and the potential of an unravelling euro project sweeps across Europe spooking investor sentiment. Meanwhile more Brexit uncertainty surges in and out of the UK.
Given this – dystopian – backdrop how did VIX readings read in May 2017? Off the scale?
Actually, the VIX slumped to its lowest score since 1993 of just 9.77. That compares with scores of 28.43 in August 2015 when the Dow sank 1,000 points in a day, and a score of almost 43 points at the end of September 2011 as the global financial crisis ground on.
So the relative post-Trump election VIX calm was, to some extent, pinned on historically low global interest rates and a measure of economic optimism (improving US unemployment, solid corporate first quarter earnings).
Keep in mind a lower VIX reading does not imply less risk. A low score can imply a sharp correction is imminent, or of significant market over-complacency. Even coming economic carnage. The duplicitous Janus face of capitalism, you might say.
“When the VIX is high,” the adage goes, “it’s time to buy. When the VIX is low, look out below.