My first blog post on June 21, 2017, was about the VIX, otherwise known as the Fear Index. At that time and for the remainder of 2017, there wasn’t much life to the VIX index because market volatility was dormant. Since February 1, 2018, however, volatility has returned and the VIX is topical again. As I write this, the VIX is at 20.45, up from just under 10 in January 2018. What is the VIX; What does VIX at 20.45 mean; How can or should an investor use the VIX in their portfolio. Parts of this blog post are taken from my 6/21/17 post but with updated numbers.
What is the VIX?
VIX is an index sponsored by the Chicago Board Options Exchange (CBOE). It is an up to the minute reflection of option premiums on the S&P 500 Index Futures. Option premiums are a function of the volatility of the underlying security – the more volatile, and higher the option premium. Thus, the VIX is a reflection of volatility in the market for S&P 500 Index Futures. The media has taken to calling the VIX the “Fear Index” because the VIX tends to rise when the S&P 500 index falls. The VIX is forward-looking insofar as it is based on option premiums in the next 30 days. The VIX is not a creamy menthol substance that you rub on your chest or head to relieve congestion.
What does the VIX value mean?
VIX is expressed as the expected 1 standard deviation of returns of the S&P 500 Index for the next year. 1 standard deviation means there is a 68% probability of an event happening. VIX at 20.45 means that, based on options premiums, the market projects there is a 68% probability that the S&P 500 will be within a range of up or down 20.45% from its current level over the next year. Mathematically, to convert this to a monthly projection, divide the index by the square root of 12 (3.46), meaning the projected 1 standard deviation of volatility for the S&P 500 is +/- 5.91%. What do you think – does it seem likely (with 68% probability) that the S&P 500 will be within a range of 5.91% up or 5.91% down within the next 30 days? I think it is probably a good guess.
The highest the VIX reached recently was about 38 on Monday, February 5, when the Dow dropped over 1,000 points, which meant that it predicted that markets would be either up or down about 11% during the ensuing 30 days. As it turned out, the S&P 500’s lowest point over the next 30 days after 2/5 was 3% lower, and its highest point after 2/5 was about 5% higher. So the 38 reading was too high, but things looked bad at the time.
How does the VIX move in relation to the S&P 500?
Usually, they will move in the opposite direction of one another. And, usually, the VIX will move will be a greater percentage than the S&P 500. If the S&P 500 goes up 1%, the VIX index usually goes down by more than 1%, and vice versa. As a result, many investors and funds managers use the VIX as a hedge against long positions in the S&P 500.
Does that mean VIX (or VX or VXX) is a good way to hedge?
Maybe. VIX can hedge systemic (or system-wide) risk to long positions you have in the S&P 500 index, but it is not a pure hedge to individual stocks. Moreover, because VX contracts expire every month, VX only works as a hedge for that month – you could purchase later month contracts, but you would pay a premium for doing so.
Can an investor “own” the VIX Index?
No, but they can own a couple of proxies, one that I believe is better than the other. The better is the VIX Future (VX), traded on the Globex Futures exchange. The VX is a Futures contract that expires every month. For that reason, my recommendation is to use the VX to hedge positions for not longer than 1 month. The not-as-good proxy for the VIX Index is an exchange-traded fund with the symbol VXX. I believe the VXX is not as good because its managers trade the VX, so an investor who owns VXX indirectly owns the VX Futures subject to the direction of the VXX managers, so owning the VX Futures is the better, more direct play for investors.
Is VIX too high or too low?
By answering this question, you are offering an opinion as to what you think others are thinking. If you say VIX is too high, then you are saying the traders who invest in S&P 500 options are too skittish, not complacent enough, or not comfortable with Pax Oeconomia. You are saying the economy going forward will be, if not robust, then at least very smooth and predictable. If, on the other hand, you say VIX is too low, then you saying those S&P 500 options traders are too complacent, that they are maybe too young to remember the turmoil of the recent past (such as 2008 or August 2015), or that they need to remove their rose-colored glasses. Also, remember that the VIX looks out for only 30 days, so that is the time frame to keep in mind for its predictive value.
IMO (In My Opinion – A Feature of All of my Blog Postings)
Back in June 2017, I wrote that I thought the VIX (at about 11 at that time) did not reflect enough risk in the markets. I was right, but it took until February 2018 for the volatility to increase, meaning that the VIX at 11 was, if anything, too high for what transpired for the ensuing 30 days. Now, at 20.45, I think the VIX is probably too high, meaning I don’t foresee an almost-6% change in the S&P 500 in the next 30 days. The news that has tanked the market during the markets since February – higher interest rates and a trade war – are unlikely to exceed expectations that are currently already baked into the markets. Time will tell.
Lastly, I believe there are better hedges for your long positions than just owning VIX proxies:
- Always maintain a balanced portfolio that includes a diversified portfolio of equities, fixed income, and alternative assets such as commodity/futures funds; and
- Unless you devote much of your personal time to keeping track of the markets, you should have a manager who does constantly watch the markets and who will re-allocate your assets in the event of a major market correction.