In the often-staid world of financial market benchmarks, anything nicknamed the “fear index” is going to stand out.
This is doubly the case when it is suggested that such an index tells us not only where we are in terms of share prices but where we are heading.
For traders and investors, this sort of predictive power is the 21st Century equivalent of the “philosopher’s stone”, the legendary substance sought by the alchemists of old in their quest to turn base metals into gold.
Paying for protection
Before examining such suggestions, let’s look at the description of the Volatility Index, to use its proper name, or VIX, by its designer and guardian, the Chicago Board Options Exchange (CBOE).
The CBOE states that the VIX is “designed to measure the market's expectation of future volatility implied by options prices”.
Trade VIX Volatility Index - VIX CFD
Currently, the VIX is close to 12-monthly highs, trading at 14.85, although this peak was also achieved a year ago, on 25 February 2019. One month back, on 24 January, it stood at 14.56, and its 12-monthly low was some way in the past, on 24 July at 12.07.
What do these numbers actually mean? The short answer is that the market is expecting higher levels of volatility over the next 30 days than was the case in July, thus traders and investors are prepared to pay more for some protection.
This protection comes in the form of options, another invention in their present form of the Chicago financial markets. In contrast to futures, the other main type of derivative, options confer the right but not the obligation to buy a security, such as a share or an index benchmark, at a fixed point in the future.
Because the option holder, unlike someone with a futures contract, can simply walk away if prices move in such a way as to make it uneconomic to exercise, the option, then those who stand on the other side of the trade, those who write options contracts, expect the risk they are thus running to be made worthwhile.
Fear of price plunges
This happens through the “option premium”, the excess in the price over what would have been charged for a futures contract.
Measuring the prices being paid for options on the Standard & Poor’s 500 index, the broader-based of the two main US indices, the other being the blue-chip Dow Jones, the VIX aims to measure market expectations of volatility over the option-contract period, usually 30 days.
Thus, the VIX is an index like any other, but it is based on option prices rather than the more conventional index based on share prices. Put simply, the more volatile the market, the higher the price being paid for options. After all, in a perfectly calm market there will be little incentive to pay for the protection options can offer.
But this volatility effect is not symmetrical. A booming market may be volatile, but if the general trend is upwards then options tend to be in less demand. It is when volatility appears to threaten jerky and sometime precipitate downward movements that action heats up in the options market.
In his financial thriller The Fear Index (2011), author Robert Harris suggests a trading operation based on such an index is capable of predicting the future. It is a cracking read, but the reality is a little more prosaic.
The VIX tells us much of what the market as a whole thinks is going to happen across the next 30 days, but if market sentiment were always correct, then everyone would be rich. Indeed, we would not actually need the VIX.
Similarly, had the philosopher’s stone really been discovered, gold would rapidly have lost its value.