Understanding the VIX Index
by Ana Maria Martinetti-Katz, MBA, CFP®, CPA – August 2011
Charles Dickens once wrote, “It was the best of times, it was the worst of times…” The stock market has certainly seen years of both elation and total panic with the debacle of 2008 being the freshest on our minds. But there are and always will be opportunities in the market for buying securities “on sale” and selling securities at a gain after they have done well. The trick, of course, is knowing when the tide will turn. Although we all know that continuously timing the market is impossible, there are tools to help gauge investor sentiment.
Since its introduction in 1993, the Chicago Board Options Exchange Volatility Index has helped gauge investor fear and market volatility. Quoted as a percentage, the VIX, as it is also known, measures the expected volatility of the S&P 500 over the next 30-day period. The VIX is a weighted measure of prices of at-the- money and out- of- the- money puts and calls for the S&P 500 Index. VIX values greater than 30 typically correspond with a large amount of volatility as a result of investor fear whereas values below 20 generally suggest less stressful times in the markets. It is important to mention that the index is an annualized amount. That is, the expected annualized change. In order to come up with the expected volatility within the next 30 day period, you must divide the index by the square root of 12.
The chart below shows the VIX Index over the last five years. You can see from the chart that during late 2008, investors were very afraid of market conditions – no surprise to us today in 2011. The VIX index in late 2008 registered at 70 (annualized). Therefore, the 30 day period following that 70 index expected to experience a volatility of 20.21%. In other words, the index options market expected the S&P 500 to move up or down by that amount within the following 30 days. In hindsight, we know that by early November 2008, the S&P 500 was down 45% from its 2007 high. Therefore, we can have some confidence in that the index accurately measures what investors are feeling and predict, to a certain degree, how they will act.
Now that we can see what the volatility index looked like from January 2007 to January 2011, what did the S&P 500 Index do during this same time period? The chart below shows us. We can see that most of the time, the volatility index and the S&P 500 index trended as expected particularly during periods of extreme fear and exuberance.
Now that we know what the index represents and that it appears to be rather accurate as far as investor fear and the consequences of those fears, what is an investor to do? By no means should investors rely on the volatility index for making investment decisions about when and what to buy or sell. Rather individuals should evaluate the index in conjunction with technical and fundamental analysis alongside a well thought out financial plan and good judgement. You do not want to blindly follow the herd nor do you want to throw darts to choose your investment strategy. Instead, you want to do what intelligent, disciplined and successful investors do. Case in point, billionaire Warren Buffet who believes one should “be fearful when others are greedy, and be greedy when others are fearful.” Remember, the index cannot guarantee that you will make money on an investment or when the best time to enter or exit the market is but it is a tool that has value in gauging how others may react to the financial and economic situation at the time. Approach with caution!