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Trading Fear: The VIX & VXX

Trading Fear: The VIX & VXX
March 29
18:05 2012

In the course of learning about financial markets, you may have heard of the notorious “fear index”: the VIX, or Volatility Index. Created by the Chicago Board of Options Exchange (CBOE), the VIX tracks the volatility of the S&P 500 index based on the premiums of all out-of-the-money S&P 500 options for the next two months. The relationship is a direct one because the premiums on those contracts will rise if the market becomes more volatile and therefore less predictable. When markets are stable, on the other hand—trending strongly in one direction (particularly up) or even just sideways—future stock prices become more predictable, and so premiums fall. As such, the more volatile the markets are, the higher the VIX goes.

The “fear index” nickname comes from the VIX’s tendency to spike during times of severe uncertainty. Its normal range is roughly from 20 to 30, but in the wake of 9/11 it jumped into the low 30s and in October 2008, as the financial crisis blossomed, it spiked into the 70s and hit highs near 90. Markets, as the saying goes, hate uncertainty, and the VIX reflects that. By comparison, since late November 2011 it has been trending steadily downward as markets have climbed, falling below 20 in the second half of January and remaining there since with only a handful of minor (and brief) exceptions.

Wall Street is known for its bits of pithy wisdom, and it has one for the VIX, too: “When the VIX is high, time to buy; when the VIX is low, look out below.” In this respect the VIX is another measure of trader sentiment, measuring bearishness and bullishness. A high VIX means a very bearish trading environment and usually signals an impending upturn. Conversely, a low VIX shows that the market is overly bullish and that a downturn is on the way.

However, while the VIX and the S&P 500 normally have an inverse relationship (that is, they move in opposite directions), on occasion they will decouple and begin moving together. This normally occurs when the “smart money” and the “dumb money” diverge. The “smart money,” composed of institutional traders like hedge, pension, and mutual funds, might begin taking defensive positions in a rising market while the “dumb money”—mostly individual, “retail” investors—are still buying madly. This sends the VIX climbing even though the S&P 500 is still rising as well, though such decoupling does not last long.

That brings us to the VIX’s usefulness as an indicator. Because large institutional investors can’t buy or sell the huge blocks of shares they typically own in a short period of time, when managers see a downturn coming, they will typically hedge with options instead. When these major players start making large option purchases, supply and demand rules kick in and the price—the contract premium—rises. Since the VIX is based on premium prices, it rises as well.

So clearly the VIX is a handy trading signal, just as the cute little saying above implies. Obviously it will be a better indicator for a broader equity investment, like the SPDR ETF, than for individual stocks. You can watch for very high or very low VIX readings to take short or long (respectively) positions on the S&P 500, though if the reversal has not yet occurred, you may have to hold your position for a little while to profit.

It’s also possible to buy volatility directly. The VXX is an exchange-traded note that follows the VIX, so you can think of it (and treat it) basically like a volatility equity. The great (but also tricky) thing about VXX is that it magnifies movements in the S&P 500, particularly when the markets are falling and volatility is rising. For example, in 2010, the S&P 500 rose 13% from June to October, but VXX fell 61% in the same period. Conversely, from April to June the S&P 500 fell 13%, but VXX rose 75%. However, because option premiums will never go to zero, as VXX falls lower and lower, its rate of decline decreases. This is a handy feature when you want to buy in near what looks like a market top, because with a very high S&P 500 and a low VXX, if the market continues to climb for a while after you buy, your losses on VXX will be minimized.

Derivatives have made it possible to commoditize virtually anything, and now VXX has done just that for fear and uncertainty.

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