Week 13: Volatility index (VIX)

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Week 13

VOLATILITY INDEX (VIX)

THE FEAR GUAGE AND HOW IT CAN BENEFIT YOUR INVESTMENT STRATEGY

The VIX index offers all investors a glimpse of market volatility as it measures fear by monitoring how aggressively option investors are betting on the stock markets future moves.

True, at times there seems a lot to worry about, especially when it comes to investments, but instead of feeding on our own fears, its far better to learn how to feed on the fears of others. The first step of course is having a reliable way to measure fear – enter the “VIX”, a market index that ‘mom and pop’ investors rarely look at.

Officially known as the Chicago Board of Exchange (CBOE) Volatility index, and unofficially known as the ‘fear index’, this gauge shows you how aggressively option investors are betting on the stock markets future moves.

More specifically, it indicates how much volatility they expect in stocks over the next month. In short, whenever the VIX is rising, investors are collectively growing more worried and when its falling they are feeling more complacent.

Obviously, investor sentiment can switch quickly, it could be caused by the Global Financial Crisis (GFC), a crash in China or a host of other less-obvious catalysts. Sometimes you don’t see the waves coming until they wash over the markets. Over the past year, the elephant in the room has been the U.S Federal Reserve and whilst no one knows how that will play out in terms of the size and timing
of future rate increases, one thing is sure and that is we can at least expect an uptick in volatility ahead of subsequent Fed meetings. So how can we use the VIX to make money? One simple way is to bet on the VIX itself and we can do this through various exchange traded funds and notes.

So, if you believe investors will continue calming down, you can buy the ‘Velocity Shares Daily Inverse VIX ETN (XIV’, which is designed to rise at a rate that is twice as fast as the VIX drops.

Another interesting correlation that you can use is the VIX’s relationship to gold prices, as historically the VIX and gold prices have often risen together, which makes sense since gold is widely viewed as a crisis hedge – precisely the thing that investors seek out when they’re worried. If you expect the VIX to rise, you could consider going long gold through an exchange traded fund, such as
the ‘SPDR Gold Trust (GLD)’, the largest such gold ETF in the world.

Another popular way to take advantage of a rising VIX and growing investor fear is to be selling options to other people. When the market reaches a panic stage, many active investors turn to buying option contracts to hedge their portfolios against large price movements, and as with any other marketplace, prices for these options contracts rise along with rising demand.

Therefore, selling options at such times allows you to collect bigger cash payments into your portfolio. Remember as an option seller, you are on the other side of the trades made by those investors who panicked along with the market. You are essentially selling insurance to them and in exchange, they pay you premiums upfront.

Remember however, according to the CBOE, that only 10% of options ever actually get used. So, whenever you sell an option that ends up expiring without being exercised, which happens 9 out of 10 times on average, you are basically walking away with free money. So even though it might seem backwards to want to sell insurance when the market is panicked, that’s exactly what you should be doing.

As we are all aware global equity markets continue to perform very well and the VIX is currently at historical lows of around 10, but remember no market goes up in a linear line, so corrections along the way generally result in periods of rising volatility and when other investors panic during these corrections, you are far better off not to join the fearful legions, but instead find ways to profit from their worries. And use the VIX to point the way.