VIX is low. Market analysts have been telling us that for months. And, many of the analysts are telling us that the fact that VIX is low means we should be worried. They believe a low VIX reading is a sign of complacency among investors.
Complacency is considered to be bad. Under this interpretation, complacency indicates investors are not paying enough attention to risk. They might become too aggressive when they forget about risk. Or, the market may simply fall when investors are least expecting.
This has become a popular theme among market analysts. One Bloomberg pundit has summed up the problem in a comical way, headlining articles “People are worried that people aren’t worried enough.”
All Time Lows in VIX
If a low VIX reading is something to worry about, now is an ideal time to be worried. The chart below shows the entire available history of VIX, dating back to 1990. In this chart, the lows are plotted. VIX is certainly near the lowest levels in its history.
- Motley Fool’s Top 2019 Stock For The Marijuana BoomSponsored Content
We recommended this stock before the marijuana boom and while it’s grown 490% since, we have a very strong conviction this is just the beginning…
VIX, or more formally the CBOE Volatility Index, is described by the Chicago Board Options Exchange (CBOE) as:
“a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices. Since its introduction in 1993, the VIX Index has been considered by many to be the world’s premier barometer of investor sentiment and market volatility.” The index has been calculated using data before 1993.
CBOE is the official provider of the exchange. The exchange commissioned a study which became the defining document for the index.
To understand whether or not low VIX readings are important, we should understand how VIX is calculated. The index is based on the S&P 500 Index. VIX is found with a mathematical formula that estimates the expected volatility by averaging the weighted prices of S&P 500 put and call options over a wide range of strike prices.
The calculation method has been changed several times since VIX was introduced. Most recently, in 2014 the calculation was changed to include weekly options contracts. By including weekly options, the VIX Index more precisely matched the 30 day target time frame that the VIX is intended to measure.
Originally, VIX was intended to be an index. But, as CBOE notes, “several investors expressed interest in trading instruments related to the market’s expectation of future volatility, and so VX futures were introduced in 2004, and VIX options were introduced in 2006.”
Options and futures on volatility indexes are available for investors who wish to explore the use of instruments that might have the potential to diversify portfolios in times of market stress.
The Fear Index
VIX is designed to be forward looking. Remember, it is intended to forecast market volatility over the next 30 days. By design, then, VIX can be thought as a measure of how concerned investors are about volatility in the next 30 days. That’s why the index is often called the “fear index.”
The next chart shows VIX and the S&P 500.
VIX is shown as the blue line while the price of the S&P 500 is the black line. By looking closely, we can see that high readings of VIX are seen when the S&P 500 is declining. Bottoms in the S&P 500 tend to occur at the same time as peaks in the VIX.
This chart illustrates the idea of the fear index. When prices are falling, VIX and the perceived level of fear in investors is rising. This leads to the corresponding assumption that low levels of VIX are associated with price highs. As the chart shows, that assumption about low VIX is not a useful market timing tool.
VIX is low right now. It was also low, as the first chart above shows, in 1993 and 2007. The second chart shows that the S&P 500 continued for some time in both cases.
Low VIX is really only telling us that volatility over the next 30 days is expected to be low. This is because VIX is a forward looking calculation of expected volatility. The relationship between volatility and pricing is assumed to exist but there is no reason, based on the formula for VIX, that this relationship must hold.
A Review of History
The next chart shows the market action in 1993 and 1994. At the end of 1993, VIX was low as prices rallied on low volatility. The price moves was almost straight up at times, which is an ideal market to be long in. There was a sell off, in January 1994, weeks after VIX reached its lows.
As the S&P 500 fell in 1994, VIX did rise. But the peak in VIX came weeks before the low in prices. For selling and buying stocks, VIX proved to be an ineffective timing tool.
The first chart above also showed low reading of VIX in 2006. The next chart shows the price action during that time period.
Once again, we see that low VIX readings did correctly forecast low volatility in the S&P 500. The S&P 500 climbed higher on low volatility, again an ideal time to be invested in stocks.
VIX did rise and the market did top in the months after VIX reached historic lows. The S&P 500 continued higher for the first half of 2007. The bear market which began late that year was devastating, but VIX did not provide a timely sell signal to help avoid that bear market.
What VIX is Telling Us
We only have two periods of time when VIX was comparable to its current low readings. Neither of those instances was precisely a stock market top. That is not to say this current stock is not overvalued and overdue for a correction. It is, in fact, overvalued and due for a correction but VIX is not a precise timing tool for major trend reversals.
VIX is not designed to be an indicator of major trend reversals. It is intended to forecast the level of short term volatility. That is all VIX does. That means we should ignore the experts warning that low VIX signals a market reversal. We should use other indicators, like long term moving averages, to monitor the trend.
What VIX is telling us is that options are relatively cheap. This is because the general level of volatility of the broad market is low. Volatility is an important component of options pricing formulas. Low levels of volatility correspond to low relative prices of options.
That means now is an ideal time to buy options. Their relative cheapness makes them attractive compared to what prices were in the recent past.
Now, since the broad stock market trading is overvalued and volatility is low, now could be an ideal time to buy put options on the S&P 500 or ETFs tracking other major market averages. Low volatility means protection against a potential decline is available at a price that is below average.
To decide which options are attractive, investors need to consider what they believe the stock market is likely to do in the next six to twelve months. If they expect a mild pull back, there is probably no need to do anything. If they expect a decline of 20% or more, out of the money put options could be bought.
These options should deliver large gains if the market declines. This is because they will benefit from a decline in price and an increase in volatility. When volatility is high, it could be best to sell options and that time will come soon.
So, rather than wondering what VIX tells us about market risk, we could consider it as input into which trading strategy should be employed.