Why the ‘fear index’ matters for all investors… and what it really is.
By Dan Ferris
The day I warned about arrived on Monday, February 5.
The CBOE Volatility Index (VIX) closed 115% higher than Friday’s close. And some investors lost everything…
Before we get to the hairy details, I bet most investors who lost money trading VIX exchange-traded products had no idea what they were buying and selling. So let’s start there…
The VIX is the result of a mathematical calculation designed to reflect the future volatility of the S&P 500 Index. Volatility is the size of price swings. Big price swings equal high volatility. Small price swings equal low volatility.
The VIX is called the “fear gauge” because it moves up a lot only when the S&P 500 moves down. Most equity investors don’t normally own put options or sell short stocks (two ways to bet on lower stock prices). They’re totally exposed to the downside with no protection.
So when stock prices drop, they get scared, rush into the market, and buy put options to protect against further losses. That quickly shoves put-option prices higher, causing the VIX to move up sharply.
That’s why the VIX works so well as a fear gauge, rather than a way to measure the size of market moves regardless of direction.
The volatility index tied to oil, for example, behaves differently because a falling oil price isn’t bad for everyone in the market. It’s bad for oil companies; it’s great for airlines. So a falling oil price doesn’t mean everybody starts selling oil. Some people buy more when it gets cheaper.
It’s only in a market like equities (where few participants benefit from lower prices) that a volatility index works well as a fear gauge.
According to the CBOE, the VIX moves opposite the S&P 500 about 80% of the time. So you’ll occasionally see the VIX moving in the same direction as stock prices during small moves. But statistically speaking, a bet the S&P 500 will drop a lot is a bet the VIX will rise a lot.
How to Calculate the VIX
We’ll keep the math to a minimum here, but it’s important for basic analytical purposes to know the VIX is a square root.
It’s the square root of the combined weighted averages of 150 to 200 near-term options and far-term options that will expire in more than 23 days and less than 37 days. (The CBOE updates the VIX options basket every minute.)
Those two components are added together, then the square root is calculated and multiplied by 100 to attain the annualized VIX number you see quoted every day. Though this number is an annualized percentage, it’s traditionally published without a % symbol.
Say this calculation gives you a VIX of 20. That means the market expects the S&P 500 to move up or down at an annualized rate of 20% over the next 30 days.
To partially avoid the complex math involved in the VIX, you can use the trader’s “rule of 16” – in which you divide the VIX by the square root of 252, the number of trading days in a year. That’s approximately 16. And you also need to understand the VIX is stated at a 68% probability. (For math geeks, the VIX is assumed accurate to one standard deviation. For the rest of us, that just means that it’s assumed there’s a 68% chance the amount of implied future volatility expressed will occur.) So going back to our example…
At 20, the VIX says there’s a 68% chance (one standard deviation) the S&P 500 will rise or fall by 1.25% (20 divided by 16) tomorrow.
Why the Volatility Gauge Is Itself Volatile…
As you can see from the below chart, the VIX itself is fairly volatile…
Even in the relative lulls of the 1990s, early 2000s, and since about 2013, it was normal for the VIX to spike upward frequently as the fearmongering headline of the moment easily influenced jittery investors.
Perhaps the most salient feature of the VIX’s historical chart is not the spikes, but its long-term sideways motion. It seems to spend most of its time between 10 and 20. This too suggests that being a VIX contrarian can yield large profits – buying when it’s down around 10 and shorting any big upward spikes above 20.
Lately, it seems the vast herd is convinced equity prices won’t fluctuate much in the future… though the recent huge upward spike could be the rude awakening they’ve failed to anticipate – signaling a period of greater volatility to come.
Over the long term, the VIX is virtually guaranteed to find new highs, new lows, and new periods of extended stays at some particular value – just as you’ll eventually see longer streaks of heads and tails the longer you flip a coin. We can’t know when those extreme values and extended lulls will happen.
Is it unreasonable to expect the VIX to settle in at some lower level, at least for the next few years? Not at all. Is it unreasonable to expect more huge spikes like today in the next few years or even a generally higher level of volatility? Not at all.
So while I’m not interested in trying to predict the VIX or any other market… the behavioral advantage tells me to do the opposite of the vast herd. Now is the time to construct an investment portfolio so well balanced, it can withstand or even benefit from higher volatility ahead.
What the Herd Is Doing, and What You Should Do Instead
Before February 5, the herd wanted to be short volatility. That means it expected fear to decrease or at least remain low and the S&P 500 to climb.
The herd looks in the rearview mirror and sees calm in the immediate past. And, indulging its recency bias, the herd expects more of the same.
But shorting volatility as a strategy is a lot like picking up nickels in front of a steamroller. You make a little bit of money… until you get crushed.
And the herd’s belief is that “the trend is its friend.”
They feel good. After all, they had been right about low volatility since the “Brexit” spike in late June, and generally right about volatility since about 2012. So they stuck with the short trade…
Until, that is, they wound up like the proverbial turkey who sees the farmer as a benefactor, providing him with ample food, water, and shelter in a peaceful, pastoral setting – until Thanksgiving comes around and the turkey is, as it were… ruined.
Only highly experienced traders have any business messing with the VIX. At best, a VIX bet is a hedge. At worst, it’s a gamble.
So before you click “buy” or “sell” on a VIX trade, you’ll want to think about where it is today versus where it has been and where it might be headed in the future…
And as I said earlier, February 5 marked a day of massive losses for many “volatility investors.”
Take the VelocityShares Daily Inverse VIX Short-Term ETN (XIV), for instance – the short VIX exchange-traded note (ETN). XIV closed at $99 on Monday, February 5… but crashed more than 80% in after-hours trading. It closed at $7.35 the next day, a 93% drop.
Products like XIV have a provision that if they fall more than 80% in one day, they have to liquidate. Credit Suisse, the company that issued the product, knew the worst possible outcome was probable. It included the following language in the June 2017 XIV prospectus, which it bolded and underlined so nobody would miss it…
The long-term expected value of your ETNs is zero. If you hold your ETNs as a long-term investment, it is likely that you will lose all or a substantial portion of your investment.
There are 64 occurrences of the word “zero” in the XIV prospectus, each one making clear this type of product can go bust. You had to be illiterate or financially suicidal to own XIV.
Not to mention, ETNs like this are essentially a scheme big banks run to borrow money they’ll never have to repay…
XIV is a debt instrument. When you buy it, you’re lending Credit Suisse money. You’re agreeing that you’ll never get an interest payment and that your principal will likely go to zero.
Most retail investors don’t read prospectuses. They didn’t know XIV could go to zero. And they got into it with everything they had…
At least one person on social media site Reddit’s “Trade XIV” group managed other people’s money and apparently had a lot of it in XIV. He posted the following…
I’ve lost $4 million, 3 years’ worth of work, and other people’s money. Should I kill myself?
I started with 50k from my time in the army and a small inheritance, grew it to 4 mill in 3 years of which 1.5 mill was capital I raised from investors who believed in me… The amount of money I was making was ridiculous… Was planning to get a nice apartment and car or take my parents on holiday, but now that’s all gone.
What’s worse is that this won’t be the last time that volatility investors get crushed.
Higher volatility lies ahead. And even those who didn’t get crushed this year aren’t out of the woods.
The VIX can and will go much lower and much higher. It’s just a matter of when. When it goes much higher than it ever has, the VIX shorts will get crushed – again.
Higher Volatility Ahead
Long-duration assets like stocks and long-term bonds are still way overvalued. The longest-term cash flows in any reasonable valuation model for those assets have the lowest value because time adds risk. You can’t predict the future. So you can’t predict you’ll receive that cash flow at all, let alone the amount you expect.
Even with the most recent volatility, stocks are still within spitting distance of all-time high valuations. Those future cash flows are valued way too highly. That’s why you saw the huge volatility spike this February. And that’s why there are many more spikes to come over the next couple years.
I continue to recommend three primary actions for you today. These guidelines should help you take advantage of higher volatility while muting its effects on your portfolio…
First, hold plenty of cash. This is the easiest way to reduce risk of permanent loss and volatility in an equity portfolio. Having plenty of cash will let you take advantage of lower asset prices after volatility has done its damage.
Second, sell short the stocks of weak businesses in weak industries.
Third, buy only when you find a good business trading at a reasonable discount to intrinsic value.
Dan Ferris is the editor of Extreme Value, a monthly investment advisory that focuses on some of the safest and yet most profitable stocks in the market: great businesses trading at steep discounts…
His strategy of finding safe, cheap, and profitable stocks has earned him a loyal following – as well as one of the most impressive track records in the industry. And his work has been covered extensively in Barron’s and other respected news outlets. He recently recommended a stock that could make you 20 times your money over the long term, with minimal risk. To learn the details, click here.