MARKET INDICATORS
On September 1, the Nasdaq was trading above 4,200, and many investors thought tech stocks were ripe to rise. If they had been watching the Volatility Index, they would have seen clear evidence to the contrary. The VIX scraped the bottom of its historical range that day, and, sure enough, share prices began a four-week decline in which the Nasdaq dropped by almost 15 percent. The optimists had ignored the fear factor.
Managed by the Chicago Board Options Exchange (CBOE), the VIX uses a complicated formula known as Black-Scholes to compute the degree of volatility priced into options traded against the Standard & Poor's 100 (OEX). Options traders buy calls when they expect prices to rise and puts when they expect prices to fall. Generally, investors buy OEX puts as a hedge against fluctuations in the larger market. Thus, the VIX measures the premium investors are paying for downside protection.
"Options are like insurance policies," says Jim Bittman, senior instructor at the CBOE's Options Institute. "When investors are anxious about the future, they're willing to pay more for them." Just as people will accept higher insurance premiums if they think an earthquake is imminent, investors will pay more for puts if they think the market is about to dive. Readings above 30 mean fear is running high; values below 20 signal complacency.
Taking advantage of this information isn't so straightforward. When investors are worried that stock prices will drop, you can infer that they've already sold out or have cash on the sidelines. When their fear subsides, that cash will flow back into the market and push share values higher. A high VIX, then, suggests prices have nearly bottomed and it's time to buy. Conversely, low readings like September 1's value of 19 suggest that investors have placed all the bets they can afford. Reduced demand will push prices down, so it's time to sell.
"The market has its own perverse brand of logic," says Scott Bleier, who, as chief investment strategist at New York brokerage firm Prime Charter, watches the VIX closely. "The market's short-term direction hinges on sentiment and psychology, which is why contrarian indicators like the VIX work so well."
The moral? The time to be worried is when everybody else isn't.
- Jonathan Hoenig (www.capitalistpig.com)
CBOE Volatility Index: www.cboe.com.
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