VIX as a Measure of Volatility

What is the VIX and is it important to your investing? Investopedia explains VIX.

Created by the Chicago Board Options Exchange (CBOE), the Volatility Index, or VIX, is a real-time market index that represents the market’s expectation of 30-day forward-looking volatility. Derived from the price inputs of the S&P 500 index options, it provides a measure of market risk and investors’ sentiments. It is also known by other names like “Fear Gauge” or “Fear Index.” Investors, research analysts and portfolio managers look to VIX values as a way to measure market risk, fear and stress before they take investment decisions.

When the market is going up or staying the same, the VIX is low. When the market is falling the VIX goes up. As an example, at the end of 2008 the VIX went from a normal of 18 up to 81 over a couple of months as the market crashed. The calculation for the VIX is complicated but what it is looking at is puts versus calls as a guide to investor concern.

The VIX is not the only indicator of market volatility offered by the Chicago Board Options Exchange. Others are these.

Cboe ShortTerm Volatility Index (VXSTSM): S&P 500 expected volatility next 9 days
Cboe S&P 500 3-Month Volatility Index (VXVSM)
Cboe S&P 500 6-Month Volatility Index (VXMTSM)

The usefulness of VIX and its relations comes from its “canary in the coal mine” property of predicting a falling market based on the actions of option traders. But, let’s get back to our question. When investments are volatile should you sell or buy? And, is the VIX useful in this regard?

The Importance of Recognizing Market Volatility

The Motley Food writes about why you should care about the VIX.

Some have dubbed the VIX the “Fear Index” because of its tendency to rise when the market drops and to decline when the market rises. Even though traders tend to interpret high VIX levels as danger points, long-term investors can use a high VIX reading as a signal to look more closely at stocks. Once the VIX has risen, some stocks might have had their share prices beaten down already, and others might have higher chances of falling to attractive levels than usual. Using the VIX as an early warning system to start looking for bargain opportunities has been a smart strategy over time, especially in recent years when long periods of low volatility were the norm rather than the exception.

We often suggest the use of intrinsic stock value as an investment guide. When a stock has been beaten down by a fearful market its intrinsic value is often the same as it was before the market panicked. Successful long term investors very often buy into a decline in stock prices in order to pick up bargains for the long term. They are not necessarily expecting the entire market to recover all that soon but the specific investments they buy are those with long term value based on fundamental analysis.

So, a high VIX indicating volatility is not a direct indication to buy but it is an indication that you should look more closely at high intrinsic value stocks that have taken a beating. A reassessment of intrinsic value may be in order. And a laddered approach of buying in increments is a good idea because nobody can precisely time the market. That having been said, when the market has fallen and then VIX falls as well, this is an indicator or stable or rising stock prices.

Why Is the Stock Price Doing What It Is Doing?

We are looking at a technical indicator, the VIX, and suggesting that you use it to carry out fundamental analysis. Why do you need to use both tools? Although markets tend to panic, they often do so for good reasons. The fundamentals, like a trade war, can cause real damage to otherwise healthy companies. We wrote about how the trade war damages investments in agriculture. When an elevated VIX tips you off to look for high intrinsic value stocks, make sure that the fundamentals that are helping drive down the overall market are not ones that will do lasting damage to your chosen investment. In the case of the trade war with China US soybean growers are concerned about the long term loss of a major buyer. Thus, when the VIX goes up and you go hunting for bargains, make sure that your assessments and calculations of intrinsic value are based on current information.

Can You Trade the VIX

Investopedia mentions in their VIX article that VIX-linked securities can be used to hedge risk and balance a portfolio.

Active traders, large institutional investors and hedge fund managers use the VIX-linked securities for portfolio diversification, as historical data demonstrates a strong negative correlation of volatility to the stock market returns ,that is, when stock returns go down, volatility rises and vice versa.

This may be a more sophisticated approach than many mom and pop investors choose to follow but it does indicate the use of this tool beyond its “canary in the coal mine” value. But, if an investor wishes to try this approach it can be a stabilizing factor in their portfolio.

When Investments Are Volatile Should You Sell or Buy? PPT

The CBOE Volatility Index (VIX), or fear gauge, soared ahead 39.9% on in Friday trading, making it the 11th greatest move in the index in more than 25 years.

Wall Street simply got spooked by worries that the end of the easy-money era is over. But let’s get real-a 25 basis point or even 50 basis point increase in the fed funds rate is hardly going to torch the bond markets and, in fact, would show the Fed’s greater confidence in the U.S. economy’s ability to both weather higher rates and continue to expand.

Despite a 2.1% decline in the Dow and a 2.5% drop for the S&P 500, both indices are less than 3% below the all-time highs set in mid-August.

Their opinion is that the current worry about a small increase in interest rates is much ado about too little. To understand how a small rate increase might signal the end of the easy money era let’s start with the VIX.

The VIX Fear Index

According to Investopedia VIX is the ticker symbol for the CBOE volatility index.

VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking, is calculated from both calls and puts, and is a widely used measure of market risk, often referred to as the “investor fear gauge.”

VIX values greater than 30 are generally associated with a large amount of volatility as a result of investor fear or uncertainty, while values below 20 generally correspond to less stressful, even complacent, times in the markets.

A VIX of 39.9% is certainly in the fear and uncertainty range. Should it be? Is the market at such risk? Normally that might not be the case but when stocks are generally overpriced it could be time for a correction.

Are Safe Stocks Really Safe?

The Wall Street Journal reports fear for the safest investments as the market stutters.

Investors who spent the summer floating serenely on mirror-calm markets have been frantically bailing out the boat in the past two days. Whether the storm that hit U.S. stocks on Friday and spread globally on Monday is the start of something much worse or merely a squall depends a lot on what explains it: the Federal Reserve, global central banks or the unwinding of excessive complacency. Unfortunately for shareholders, the signs point to the latter.

In a normally priced market and with more normal interest rates it would not be a huge deal to see an increase of a quarter percent or so in the Federal Funds rate. The problem is that rates have been historically so for 8 years and the market has come to assume they will remain so. Overpriced stocks, especially dividend stocks that will get hurt with higher rates may be in for a big correction. This pending end of the easy money era is seen in the abrupt rise of the VIX fear index.

End of the Easy Money Era PPT

Investing in discounted stocks such as the high tech giants listed above involves finding stocks with a margin of safety, the concept that has guided value investors for more than seventy years. Often these are dividend stocks as the companies in question have little debt and lots of cash. Many times these companies will actively buy back stock in an effort to boost stock price to the benefit of their stock holders. Companies with substantial physical holdings also qualify when investing in discounted stocks as the market often does not appreciate the value of these assets. Investing in discounted stocks is not just investing in companies with cash as many companies with cash and paying dividends are fairly valued and not likely to appreciate rapidly. The point of buying a discounted stock is not only that there is the margin of safety supporting its value but that sooner or later the market prices in the value of currently ignored holdings. The market eventually recognizes that the company is making more money effectively bids the price up.

Which are the discounted stocks? Those listed above seem to qualify as they are priced ten to thirty percent below what the market is paying for other stocks based upon income stream and asset value. Looking for low price to earnings ratios is a time tool for investing in discounted stocks. The investor pulls up a screen of low PE ratio stocks in a given market sector or in a large, medium, or small cap range. Then the investor investigates each stock in succession looking for cash and absence of debt, physical assets, ownership of subsidiary companies, and other measures of asset value. Investing in growing companies is not just limited to startup companies and penny stocks. We are not suggesting that the investor go out and buy any of the stocks listed above or than he or she ignore them. Rather it is useful when investing in discounted stocks to develop a strategy that is successful in picking new winners in the stock market.

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