Trading changed a great deal in 2018. Before then, market trends fundamentally pointed upwards. That was still the case during the 2008 subprime mortgage crisis. It was still a classic “bull market” where the right investment choice was to buy. However, in February of 2018 the market collapsed in a matter of days. That was the first ominous sign for the future prospects of global economic growth. Disagreements over tariff policy, US interest rate hikes and a number of geopolitical conflicts all hurt the stock market outlook. The asset that benefited most from this rising uncertainty was the Volatility Index.
For a brief moment in February 2018 the index spiked to 37 points. Fortunately, after that it mostly returned to normal levels. There was another in March, however, it was notably smaller. A few months later in October it once again started moving in the 15 to 30 point range. During a typical bull market period the VIX usually moves between 10 and 15 points. Those numbers suggest a fundamentally calm market. When above 15 points, it indicates a significant degree of economic uncertainty.
The Market Volatility Index index has been available as a Futures contract in Chicago since 1993. Traders & investors often call it the “fear index”. Its creator is the Chicago Board Options Exchange. You calculate it from the 30 day premiums of S&P 500 index derivatives. When the market is willing to pay a higher premium on options expiring in 30 days, it shows that market participants see a realistic possibility that prices will be higher in that time period. When options traders are willing to risk money on the prediction that options will trade at a higher price in the future, then the movements and range of the actual market will presumably follow suit. On the other hand when investors are nervous and uncertain, they’re more willing to pay higher premiums for closer strike rates.
In reality the VIX is primarily a sentiment index. It effectively compiles the outlook of market participants not through a questionnaire, but rather looking at where they actually invest their money. Moreover it doesn’t do it on a monthly basis, but minute to minute. This way it gives a real-time view of the current mental and emotional state of the market. It truly justifies calling it “the fear index”. On the other hand, the fact that it’s based on predictions also means that it projects the expectations of the market. This can often turn into a self-fulfilling prophecy as traders grow increasingly uncertain when they see the index rise.
Other Volatility Index Types
It’s important to note that conventional volatility indicators are based on past data. They take a look at the difference between recently recorded minimum and maximum values, then use it as a basis to project the future range of movement. This is what we call “historical volatility”. It’s obvious that attempting to predict the future by only looking at the past is inherently a high risk endeavor. These kinds of metrics can play a key role in projecting future results, however, they fail to account for the psychological factor. This is a major flaw considering that investor sentiment is a much more powerful force on the market than mathematical probability. When making investment decisions one needs to price in the future, not the past.
CBOE Volatility Index (VX) Futures
As an instrument the index becomes tradable at a one thousand dollar multiplier. This means when it’s at 20 points, one Futures contract is worth $20,000. The smallest unit of measurement is 0.05 points so one tick is worth fifty dollars. The asset is released with weekly expiries, making the front contract extremely short lived. At times it could move as much as 1-2 full points within a day. That translates into a win or loss of $1,000-$2,000 per contract depending on the direction.
How to fit the VIX into a portfolio?
A better question to ask would be why it’s worth paying attention to. Futures trading isn’t suitable for every investor. However, even those who don’t plan to trade it themselves can glean useful information from it. One of the fundamental assumptions about the Volatility Index is that there is a significant negative correlation between the market declining and volatility rising. There are numerous statistical and economic analyses that back this observation as a fact. In addition, anyone who’s ever traded on a predominantly bear market will tell you that it’s true. That said, high volatility on its own is not sufficient to make the decision to sell. It fails to answer the question of exactly how much the S&P will actually move. Even if this correlation holds true.
It would be misleading to claim high Volatility Index levels as the ideal opportunity for an S&P 500 short position. The year 2018 has shown us that stock indices can make sharp corrections even within a single day. These movements would only be reflected in the options market and the VIX, much later.
Taking all of the above into consideration, the VIX is still an index that intimately ties into market expectations. It’s invaluable for signalling the possibility of a reversal. That remains true even if it doesn’t give you the exact time for when to open a position. Declining volatility indicates a slow rise for the stock market. This could either be favorable for buying or simply the calm before the storm. A rising VIX on the other hand shows growing tensions. That could be a good chance to think about where one would open a short position. You also need to acknowledge that there is an element of seasonality to the index. Flash report season can cause high volatility even during an otherwise calm market period.
Its function as an indicator means you don’t necessarily have to trade it to make a profit off it. However, it’s still an exciting instrument all on its own. A flatlining index suggests the recent release of some alarming news and the longer the silence the closer the bang. Its small contact size also makes the VIX suitable for profiting off market uncertainty when used cautiously and deliberately. All in all, it’s an asset well worth your attention at least.