The Fear Index really allows you to make money on investor sentiment. While some start to panic, others take advantage of the turmoil. Here’s how it works.
Investors always want to anticipate price movements. To do this, they use different ways with varying degrees of science and usefulness. One way is to use leading indices, which include volatility indicators. The best known of these indicators is the Chicago Board Options Exchange Volatility Index VIX. It is also known as the fear index.
How the VIX Fear Index works
Analysts and investors who use the VIX believe that it measures market sentiment regarding future volatility. In other words, this index shows the level of fear investors have about future market movements.
Knowing the level of investor apprehension now suggests in which direction the aggregate investor sentiment will point. So how are these concerns measured? The main idea behind the use of a volatility indicator is that it is based on option prices. Therefore, to understand how it works, we need to understand how an option is structured.
What is an Option
The option is a special exchange contract, which gives the investor who bought it the right to buy or sell an exchange commodity at a certain price.
In a classic stock exchange deal, the question is about the obligation, not the right. Because of this characteristic, the option is often used as market insurance for investments. How is this achieved? Let’s look at how options are used, using oil as an example.
Oil Option: Calculation Example
Let’s say a trader buys oil at $63.2 and at the same time an investor buys an option to sell oil at $63.2 (the strike price of the option) and pays for it a certain amount of money – the option premium. Let the option premium be $1.5. With this right, the trader insures his investment in case the price falls.
If the price of oil rises to $70, the trader will get $6.8 from each lot. After deducting the $1.5 deductible, the investor’s net profit will be $5.3.
But if the price of oil falls to $55, the trader can exercise the right, which gives him the option and sell his oil for $63.2. Then the investor will lose only what he paid for the option – exactly $1.5.
This put option is called a put option – in English, it is called a put-option. A call option is called a call option. In English, it is called call-option.
It is clear that in the example for the oil price the put-option at $64 will be more expensive than at $63.2. Traders who sell exchange-traded commodities are engaged in the same risk limitation. Some of these players open a short position when they sell.
These traders generate demand for call options. Accordingly, the current ratio of sellers and buyers, as well as their sentiment and expectations of future price movements, will manifest themselves in the prices of put and call options. Thus, by matching option prices, we can numerically determine investor sentiment about relative price movements.
What does this have to do with investor nervousness?
The VIX indicator is based on this pattern. It uses options prices for the S&P 500 index for its calculation. Thanks to index ETFs and index futures, the S&P 500 has in some ways become a commodity itself.
The more investors fear a market decline, the higher the premiums on put options rise and the lower the premiums on call options fall.
Conversely, if the market is confident of a rise, the premiums on call options will go up and the premiums on put options will go down.
But if the market is not sure of the direction, then most participants are afraid of unforeseen movements and hedge against them. This will manifest as an increase in the premiums of all options – both put and call.
The index is calculated in such a way that the larger the premiums, the higher the value of the VIX index.
Fear Scale from 0 to 100
The values of the VIX index, in theory, are located on a scale from 0 to 100. The index has been calculated since January 1990. The maximum historical value of 89.53 points was reached by the index on October 24, 2008, the minimum – 8.56 points – on November 24, 2017. Most often, the values of the indicator are located in the range from 15 to 40.
If the value of the indicator is below 20 or 15, then investors’ fears of a market decline are small. It means that the markets are in an upward trend in the medium and long term. The very reduction of the VIX below 20 can be perceived as a reason to think about buying U.S. securities in the long term.
If the value of the indicator exceeds the level of 70-80, then theoretically it should mean that traders try to insure themselves as much as possible. And not only from fluctuations but also from a deep fall of the market.
After the indicator reached its maximum in October 2008, the US indices continued to fall, reaching the bottom in March 2009. It should be mentioned that in practice, the indicator has had values over 50 only from October 2008 to March 2009. So it was no longer feasible to actually use it to predict the downward trend.
Most often, traders prefer to focus on the upper limit of 45. Finding the indicator above 45 means that the level of fear in the market is high enough, and it is worth refraining from buying for the time being. However, overcoming these levels should not be perceived as a signal to sell.
If you hold liquid U.S. stocks in your portfolio, a VIX above 20 might be a selling signal. In addition, it is worth watching for local lows in the Volatility Index.
When the next local low of the index is greater than the previous value and the corresponding new values of the stock indices (Dow Jones and NASDAQ) are greater than the values on the date of the previous local VIX low, it is the so-called divergence – divergence. In such cases, many investors close part of their long positions.