The VIX, or Volatility Index, is well known among investors but is often misunderstood.
The VIX is the Chicago Board Options Exchange’s (CBOE’s) Market Volatility Index, which measures the market’s expectation of 30-day volatility, or “implied volatility,” for the S&P 500 Index. The VIX is often referred to as the “fear index” because it measures investors’ expectations of future volatility.
Why do many investors misunderstand volatility? A simple answer is that many tend to overestimate it. Investors tend to be risk averse, often fearing that their investments will fall. Yet “implied” or expected volatility rarely materializes into actual or “realized” volatility.
The VIX routinely experiences larger fluctuations and movements as compared to the actual S&P 500 Index results. In other words, investors’ fears of future declines tend to be much greater than the actual declines.
How is it calculated? The VIX is calculated by taking a weighted average of all the options prices on the S&P 500 Index. This single number is the VIX. When options premiums fall, the VIX falls; when options premiums rise, the VIX rises. The greater the risk of volatility, the higher the options premiums; the lower the risk, the lower the options premiums.
What’s a long vs. a short volatility position? A long-volatility position can be compared to buying protection for your equity portfolio. A short-volatility position can be compared to selling protection and seeking to be compensated over time for assuming the risk. Because investors often tend to overestimate volatility, short-volatility strategies have outperformed long-volatility strategies over the long term.
What’s a high number for the VIX? Historically, a VIX below 20 has meant that the market has forecasted a healthy and low-risk environment. A VIX higher than 20 has typically shown that investors have started to fear the market, projecting a higher-risk environment.
During the financial crisis of 2008-2009, the VIX spiked above 50. Yet, comparable periods when the VIX has risen showed that the index reverted to the mean rather quickly. A reasonable explanation for this is that volatility is an ongoing cycle. Even during the most volatile periods in history, spikes in the VIX have been followed by reversions to the mean.
Can I invest in the VIX? While the VIX serves as a hedge for equity exposure, you can’t buy the VIX directly. Instead, you can buy futures contracts on the VIX or Exchange Traded Products. But these products aren’t meant for long-term exposure, and they can be expensive.
The material provided herein has been provided by Measured Risk Portfolios, Inc. and is for informational purposes only. Measured Risk Portfolios, Inc. serves as investment adviser to one or more mutual funds distributed through Northern Lights Distributors, LLC member FINRA. Northern Lights Distributors, LLC and Measured Risk Portfolios, Inc. are not affiliated entities.