When Markets Are Scary, Look to the VIX

OK, two screenshots. On the left is my net worth as of the close on Thursday, 2/1/18, and on the right is my net worth as of 11:14 AM on Tuesday, 2/6/18.

That includes capital assets, but if you break out the paper value of our investments we’re down roughly 5.5% in five days. I could go on and on about how I feel about a 5.5% drop–good, bad, indifferent?–but I won’t. There’s no point. You’ve heard all that from other sources; sources that either reassure you or smite you with boiling fantods.

From the looks of my various social media feeds, I speculate that most of the people being smitten with boiling fantods weren’t investing between 1997 and 2001, nor were they around during the bursting of the housing bubble in 2008. But so what? Just like back then, it’s obvious to everybody that there’s a lot of volatility in the stock market now.

So instead of getting into the whole buy/sell/hold/hedge debate, let’s talk about the volatility itself…specifically a volatility measure called the “VIX” and how to interpret it.

(Familiar with the VIX? Move along, folks. Nothing to see here.)


What I haven’t seen much of, or at least in commentary intended for the small investor,1 is an explanation of the VIX ( AKA Chicago Board Options Exchange Volatility Index), and why TV and web experts2 bring it up.

You’ll often hear the VIX called the “fear index.” Think of it as an indicator of risk appetite: how comfortable are investors with what’s going on?

Let’s look. Here’s a five-day chart of the VIX as of 11:48 AM on 2/6/18. Check out the spike. Not in the least surprising for an index purported to measure fear in the markets, right? So how’s the VIX determined?

First, the VIX isn’t forward-looking. It’s the simple result of a complicated calculation that uses the real-time prices of thirty-day S&P options data as a proxy…a reasonably good one, as it happens, for near-term investor expectations of annualized S&P return. (An in-depth explanation is here.)

A higher VIX indicates that investors expect more volatility; a lower VIX indicates that investors expect less. Since volatile markets cause higher options premiums,3 you get spikes like the one shown.

In short: nobody knows what’s going on so nobody wants to make a move without pricing in their perception of the risk involved. And that’s why they call the VIX the fear index.


With a clearer understanding of the VIX, let’s now get back to the aforementioned dot com and housing/credit bubbles. Here’s a chart of the VIX since 1997:

See where the VIX was turbulent during the dot com boom and its bust and subsequent recession until the recovery took hold? And see how that pattern repeated itself during and after the housing/credit crisis?

Now observe that while the rightmost spike in the VIX–Monday–was the largest single-day jump in its history, its current level is nowhere near its peak…meaning to me, at least, that while in the last few days the broad market has suddenly became less certain of direction, it isn’t (yet?) uncertain to the degree it was during two prior catastrophes. Not as afraid, in other words.

Which is good news, right? Maybe. Take what comfort you find in it…but in any case, knowledge is a good thing. So when the talking heads bring up a spiking VIX, you’ll now have one less unknown to be afraid of.


Sheesh…I finish this article and split to see a movie and get back home and find the Dow’s up 500 points, for a 900-point daily range. Ironic that I brought home a bunch of popcorn.4

Footnotes

  1. Which is such a frigging misnomer. I get that the term small is a reflection of the size in dollars of an investor’s exposure to the markets, but say your daughter is thirteen and you have 75% of her $40K 529 invested in index funds and you’re watching those funds take a colossal dump…well, to my way of thinking you’re just as exposed as anybody else, if not more.
  2. Which I think is likewise a misnomer. I know  these people get paid to offer market insight to the masses, but in a world where only one in twenty fund managers beat the S&P across the long term, I don’t find such commentary to be compelling. Hell, I don’t even find my OWN market direction commentary to be compelling, which is why when discussing equities markets I do my best to stick to the facts.
  3. Simple illustration just in case you need it: nobody would sell to somebody for ten cents the right to buy their shares of whatever if they expected those shares to go ten bucks higher in thirty days, right?
  4. The AMC $4.50 refillable bucket, by the way…not the stuff you have to sell your cat into slavery for.

Author: ER Dude

Sick of your job? After a thirteen-year career, Early Retirement Dude fled corporate America for good. You can do it too! Visit http://EarlyRetirementDude.com or email EarlyRetirementDude@gmail.com.

9 thoughts

  1. Pretty good summary. Though I think you missed a great opportunity to point out since it’s not truly forward looking it only represents what is known today. Tomorrow could be completely different. Ie VIX May not tell you anything, you might instead need preparation IPS

  2. Cat slavery isn’t funny bro. What the privileged 1% don’t want you to know is that many stray cats are forced into menial jobs, like barista or troubadour, with no compensation and only fed off brand kitty chow. We should be raising awareness of this sinister practice rather than worrying about meaningless stuff like what the market is doing. #endslaverymeow

    1. Interesting question. My take? Politics have always been a cause of uncertainty, of course, but this administration has been in power for a year now and the VIX has been relatively stable. That said, the recent business-oriented tax package has recently stirred things up, as has the prospect of a government shutdown.

      Business opportunity, maybe…pitch the “Game of Thrones” index to the CBOE. 🙂

  3. Thanks for explaining the VIX, also adding to my vocabulary.
    The new word of the day for me “Fantods” -a state or attack of uneasiness or unreasonableness.
    Not sure how one would go about boiling them?

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