When you check out almost any financial media source these days, you’re likely to hear references to the VIX, or as it’s commonly known, the “Fear Index.” However, what is it, and what exactly does it measure?
For investors who want to have a finger on the pulse of the markets and are always on the lookout for bargains, the CBOE Volatility Index (another name for the VIX) is a great tool.
As we might expect after several weeks of 1,000- to 3,000-point swings in the Dow, the volatility index is high. This GuruFocus chart shows that it was more than 75 at the close of trading on March 13, 2020 after a year of staying mostly below 20:
The index reflects how much investors think the S&P 500 Index (SPX, Financial) will fluctuate in the coming 30 days. It is calculated with a mathematical formula that analyzes differences between monthly and weekly options (for a full explanation of the math, visit the CBOE website).
In addition to telling us how nervous the market is at this time, the VIX also gives us a comparative view. Below is a VIX chart that goes back to the beginning of 1990. Note that GuruFocus gives us the option of displaying American recessions, and they show up in the white verticals:
Based on this chart, we can confidently say that investors have not been this afraid since late 2008. At the Macroption website, they report that the highest-ever reading was 172.79 on Black Monday; that’s more than twice as high as the peak in 2008. They noted, though, that the extreme reading was actually based on the VXO, which was the predecessor to the VIX.
Some exchange-traded fund providers offer what are known as VIX ETFs, allowing investors to indirectly invest in the volatility index (it’s not possible to buy the VIX directly). Some might see these ETFs as a form of insurance against a serious dip in the markets, but this is not true. That’s because they use future contracts, which are very risky.
How should we react if the market shows high volatility? For one, we should expect valuations to fluctuate quite severely over the coming month or even months, which will be both a caution and an alert.
Another useful metric for measuring market sentiment is the “put-call ratio." Puts and calls are the two types of stock options and are formally known as “derivatives” because their value is based on something else. In this case, options derive their value from their underlying securities, stocks and ETFs.
Put options are commonly used to provide protection for an individual stock or portfolio. When the owners of stocks buy puts, they are buying insurance against a drop in prices. The investors on the other side of the trade, the sellers, are acting like insurance companies. The buyers pay a premium to the sellers upfront. If the stock price drops below a threshold point (called the "strike price"), then the seller is obligated to buy the now-devalued stocks.
Investors buy call options because they are bullish about a stock or ETF; they believe its price will rise within the period specified by an options contract. Therefore, they pay a premium to a call option seller now, and that gives them the right to buy the seller’s shares at specific price before the option contract expires.
If the buyers of the call options are correct and the stock rises as expected, then they will get the stock at a discounted price or simply sell the contract to someone else. Either way, they pocket the premiums and earn a profit. If the price does not rise as expected, they will have lost less money than they would have by purchasing the stock outright.
For the sellers of call options, they receive premiums upfront and that’s an immediate profit. If the stock price rises above the price in the contract, then the stock will be “called” away. Whether that’s profitable will depend on the purchase price.
To use an imperfect analogy, the put side of the options business represents fear in the market, while the call side represents greed in the market. Thus, if the demand for puts is stronger than the demand for calls, then the market is fearful (to whatever degree). If the demand for calls is stronger, then the market is more concerned with profits than with managing risks.
At first glance, we would expect a put-call ratio of 1 to be a neutral position, with equal demand for puts and calls. However, in a normal market, there are more call buyers than put buyers. When that is calculated into the mix, the neutral point is 0.7. Therefore:
- When the put-call ratio is greater than 0.7, the market is thought to be bearish because investors are buying more puts than calls.
- If the put-call ratio is less than 0.7, the market is considered bullish because there is more demand for calls than puts.
Since options originate with the CBOE (Chicago Board Options Exchange), the CBOE website is a reliable source of information about the put-call ratio. It reports several forms of put-call ratios, including the following three, as of the close of trading on Monday, March 16:
- For exchange-traded products (funds and notes): 1.53
- For equities (stocks in general): 1.10
- SPX (S&P 500): 1.75
Obviously, the current ratios are well into bearish territory, confirming what we see in the VIX.
Conclusion
The VIX, or Fear Index, and the put-call ratio are two more tools for measuring investors’ feelings about the market. It’s helpful to be aware of them when markets are in turmoil, as they have been since Feb. 19.
For value investors, this is a time to wait and watch for bargains among the stocks they follow. With serious declines on a near-daily basis, it may soon be time to go shopping. Following the VIX and put-call ratio may help make this form of timing somewhat easier, by putting current prices into a broader context.
Read more here:
- Market Valuation: Are We There Yet?
- Book of Value: Investing as a 'Negative Art'
- Book of Value: Purveyors, Victims and the Stock Market
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