Investors were popping champagne bottles at the end of 2014 as the S&P 500 chalked up another year of above average returns, amid fairly low levels of market volatility. But, equity market action in early 2015 suggests a whole new ball game is starting now. Equity market volatility has increased amid heightened uncertainty among investors on the outlook for stocks ahead.
Several times in recent months, the CBOE Volatility Index or VIX® has pushed above the 20 percent level, which signals fear or uncertainty among investors.
What is the VIX? "The spot VIX is a measure of S&P 500 volatility over the next month— the higher the percentage the greater the fluctuations we can expect in the near-term. It is typically higher during times of a market pullback or correction and lower when prices are going up, said Mitchell Warren, founder of OptionsRiskManagement.com.
The current unsettled feeling among investors may trace its roots back to October 2014, which saw the S&P 500 tumble sharply from a peak at 2016 in mid September to 1820 in mid October.
"Since the correction in the fall of 2014 there has definitely been more fear in the market. People aren’t as complacent as they were during the 2013 rally. Market participants are more willing to purchase hedges in the form of SPX index options and VIX calls," said Warren.
Traders monitor so-called "extremes" in the VIX —either very high levels or very low levels in order to inform their trading decisions. What's an extreme high? "Readings of 30 or higher are signs of a market panic. This means that investors are willing to pay anything for S&P 500 index options to hedge their portfolio since they were caught off guard by the market reversal," said Warren. See Figure 1 below.
On the lower end of the spectrum, readings in the 10-12% zone reveal complacency or a lack of fear in the marketplace. In mid January, the VIX did poke back above the 20% barrier, which is the lower reaches of an upside extreme.
As of late January, the VIX stood around 16% —or no man's land. "Right now the best trade for someone who want to trade volatility is no trade. One could look to buy VIX calls if it drops another three to four percentage points," Warren said.
Looking ahead, the VIX will continue to offer clues on the level of fear in the equity market and also insights for traders.
"For the last two-plus years the Volatility Index has, for the most part, been in a range between 12 and 22. In times when it is near the lower end of the range I am usually at least reducing my U.S. equity exposure and sometimes actually buying VIX calls that have an expiration date one to two months out —in hopes of selling the calls in the high teens, low 20’s. When it has climbed into the 20’s that is a time when I’m looking to take advantage of the fear in the market and buy high quality stocks for a discount," Warren concluded.
Chart source: StockCharts.com, annotated by OptionsRiskManagement.com