What is the VIX?
Buy low, sell high. The trend is your friend. Sell in May and go away. Wall Street is teeming with familiar financial adages. But there’s one you may not have heard of: “When the VIX is high, it’s time to buy.”
Similar to “buy the dip,” the idea is that when the level of fear in the markets has reached its peak, it’s the perfect time to buy because stocks are most likely trading at deep discounts. To quote famed investor Warren Buffet of Berkshire Hathaway (NYSE:BRK.A,NYSE:BRK.B), “Be fearful when others are greedy, and greedy when others are fearful.”
But what is the VIX? Here the Investing News Network answers that question and more, including whether or not the old saying still holds true in times of heavy uncertainty.
What is the VIX?
VIX is shorthand for the Volatility Index (INDEXCBOE:VIX) of the Chicago Board Options Exchange (CBOE). Since 1993, the VIX has tracked real-time price changes of near-term S&P 500 (INDEXSP:.INX) options.
Options are financial contracts that give holders the right to buy or sell an underlying asset — stocks, bonds, exchange-traded funds, contracts, etc. — at a certain price within a certain time period. Options prices for particular stocks are determined by the probability that the stock’s price will reach a certain level, known as the strike price or exercise price. The VIX tracks the S&P 500 as opposed to other indexes because it is considered the leading indicator of future volatility in the overall US stock market.
For many knowledgeable investors, the VIX is a globally recognized go-to benchmark index for measuring the expectation of volatility in the stock market over the next 30 days based on how wide or narrow the swing in prices is for S&P 500 options.
Why does the VIX go up when the market goes down?
The VIX has an inverse relationship with the S&P 500, meaning that spikes in the VIX typically occur when stock prices drop.
The more pronounced the options price swings on the S&P 500, the higher the risk of stock market volatility and the higher the VIX climbs — a signal that a crash may be imminent. On the flip side, a significant drop in the VIX could herald a rally.
It’s important to note that the VIX is not a crystal ball, but rather a real-time snapshot of how investors are feeling about the level of near-term volatility in the market. Is the current sentiment negative or positive? Confident or fearful?
“Volatility, or how fast prices change, is often seen as a way to gauge market sentiment, and in particular the degree of fear among market participants,” explains Investopedia. Hence why the VIX is also referred to as the “fear index.”
Investors can use the VIX to measure the level of fear in the market and employ this information when making investment decisions. The higher the VIX level, the more likely the possibility that fear and uncertainty is driving the markets.
What is a normal range for the VIX?
The normal range for the VIX is values ranging between 12 and 20. Forbes advises investors that when the VIX is below a value of 20, that is reflective of a stable investment environment. A VIX value of 12 or lower is indicative of high optimism in the stock market — the mark of extremely bullish investor sentiment.
Once VIX values rise above 20, the market is said to be experiencing “abnormally high volatility.” Once the VIX is seen pushing above 30, that’s a clear sign of a bear market — when investors fear there is too much uncertainty and risk in the stock market.
In fact, five of the 10 highest VIX values since the index launched in 1993 occurred in the lead up to the 2008 financial crisis, while the remaining five are associated with the COVID-19-induced stock market crash in 2020.
The VIX hit an all-time high of 82.69 on March 16, 2020, during the early days of the COVID-19 pandemic. The index’s second highest value (80.86) was reached on November 20, 2008, as markets reeled from the fallout over mortgage-backed securities.
Can you invest in the VIX?
While you can’t invest directly into the VIX, there are a number of exchange-traded products (ETPs), such as futures contracts, options contracts and ETFs, that are based on the future anticipated value of the index.
Three such VIX-associated ETFs are:
- The ProShares VIX Short-Term Futures ETF (BATS:VIXY), which offers investors exposure to the S&P 500 VIX Short-term Futures Index, is designed for those investors looking “to profit from increased volatility in the S&P 500, as measured by the prices of VIX futures contracts.”
- The iPath Series B S&P 500 VIX Short-Term Futures ETN (BATS:VXX) seeks returns linked to the performance of the S&P 500 VIX Short-term Futures Index by providing short-term exposure to futures contracts of specified maturities on the VIX index. As an exchange-traded note (ETN) rather than an ETF, VXX is backed by Barclays’ (NYSE:BCS,LSE:BARC) credit instead of by assets.
- The iPath Series B S&P 500 VIX Mid-Term Futures ETN (BATS:VXZ) is also linked to the performance of the S&P 500 VIX Short-term Futures Index, but the exposure is to longer-dated futures contracts. This factor makes VXZ less subject to the significant contango-related return erosion seen by short-term products like VXX or VIXY.
If investors are able to get the timing right, VIX futures ETFs can be a hedge against a market crash. However, the opportunities inherent in VIX ETPs don’t negate the fact that they do carry significant risk, and are not for those with a longer-term investment strategy or low risk tolerance. Analysts at ETF.com warn that these products “deliver poor long-term exposure to the VIX index,” and they “have a history of erasing vast sums of investor capital over holdings periods as short as a few days.”
In other words, VIX ETPs have a tendency to suffer from contango. If held for too long a period, they lose their value, making them an unsuitable permanent hedge against market volatility.
Investors with high risk tolerance and a knack for playing the short game can also buy VIX call options as a potential hedge against stock market downturns. But once again, as Investopedia cautions, it’s important to time the market right. Buying in the middle of a market crash can lead to oversized losses.
Can the VIX really predict a stock market crash?
Is the VIX really a forward-looking index that can accurately predict future volatility? Not everyone thinks so.
Speaking to CNN Business in September, Aaron Anderson, senior vice president of research at Fisher Investments, questioned the value of the VIX as a weathervane for which direction the stock market is moving.
“There’s just no correlation to future returns. We’ve never understood why so many people accredit so much to the VIX,” Anderson told Senior Markets Reporter Nicole Goodkind.
Heading into 2023, many market watchers are sounding the recession alarm. 2022 has inarguably been fraught with serious levels of uncertainty, from whether or not supply chains can recover from the COVID-19 pandemic to Russia’s war in Ukraine, which has placed strain on many commodities, including energy, sunflower oil and wheat crops. And of course, rising inflation has led central banks around the world to hike interest rates, including the US Federal Reserve.
And yet this high level of uncertainty has not been reflected in the VIX, which came in at 19.53 in mid-August, shot up to 33.57 in mid-October, then eased back down to 24.55 as of November 4. This is a far cry from the 10th all-time high for the VIX, the 72 level reached on March 19, 2020. “The VIX tells us almost nothing beyond how much markets have been bouncing around lately,” said Cliff Asness, founder and chief investment officer of AQR Capital Management.
Perhaps the VIX is not a predictor of where the market is headed, but rather a gauge of the current investment environment.
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Securities Disclosure: I, Melissa Pistilli, hold no direct investment interest in any company mentioned in this article
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