Today I am starting to blog. My goal is to make 2 posts per week that will be informative for most investors. Hopefully I will find topics that are current but that aren’t thoroughly explained in other places. Let’s jump right in!
Much is being written about the VIX, or the Volatility Index, because, despite its value dropping significantly, volume in VIX-related trading has boomed in the past 5 years. Trading volume in VIX-related securities is at an all time high as I write this Currently the VIX Index is at 11.46. The VIX Index was under 10 during parts of last week.
What is the VIX? What does VIX at 11.46 mean? How can or should an investor use the VIX in their portfolio?
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.
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 11.46 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 11.46% 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 +/- 3.31%. What do you think – does it seem likely (with 68% probability) that the S&P 500 will be within a range of 3.31% up or 3.31% down within the next 30 days? I think it is probably a good guess.
What if the VIX was at 20? Rule-of-thumb is that VIX at 20 indicates an elevated level of “fear” in the markets. At 20, instead of +/- 3.31% over the next month, the options market is projecting S&P 500 returns of +/- 5.77% over the next month. That’s a big difference.
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 say 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.
IMO (In My Opinion – A Feature of All of my Blog Postings)
I believe there is a lot more downside risk out there than is reflected in the current level of the VIX. The market has risen so much since November 2016 that there are bound to be corrections. Moreover, the rise since November 2016 is a continuation of the rise that commenced after the depths of the 2008-2009 correction caused by the sub-prime loan crisis. The market has evolved a lot in the last 10 years, with program and high frequency trading now major sources of volume. Dodd-Frank has taken traditional sources of market liquidity (commercial banks) out of the trading game, and they have been replaced by hedge funds and other private sources. We don’t know what will happen to market liquidity if and when the market corrects more than these algorithms think that it will correct. Will the hedge funds be there to shore up the markets? We don’t know. This is not to say that I think the market has topped and will now correct. No, my indicators say we are still in a bull market. However, I do believe there is a huge tail risk that is not encompassed in the current level of the VIX. Lastly, I believe there are better hedges for your long positions than just owning VIX proxies: 1) Always maintain a balanced portfolio that includes a diversified portfolio of equities, fixed income, and alternative assets such as commodity/futures funds; and 2) 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.