Degree of fear in global financial crisis as shown in VIX

Reprinted from Business Times (21 Oct 2008)

(NEW YORK) Fear is running high on Wall Street. Just look at the Fear Index.

VIX at 70 suggests investors see S&P 500 up or down 20% in 30 days

With all those stomach-churning freefalls and sharp day reversals in the stock market recently, traders are keeping a nervous eye on an obscure index known as the VIX.

The VIX (officially the Chicago Board Options Exchange Volatility Index) measures volatility, the technical term for those wrenching market swings. A rising VIX is usually regarded as a sign that fear, rather than greed, is ruling the market. The higher the VIX goes, the more unhinged the market looks.

So how scared are investors?

On Friday 17 Oct 2008, the VIX rose to 70.33, its highest close since its introduction in 1993. It stood at 67 in early trade yesterday.

To some experts, that suggests that the wild ride is far from over.

'Right now, it's an extremely important part of the puzzle,' Steve Sachs, a trader at Rydex Investments, said of the VIX. 'It's showing a huge amount of fear in the marketplace.'

The VIX is hardly a household name like the Dow. But lately, it has become a fixture on CNBC and other financial news outlets, with commentators often invoking an index that most of the general public was blissfully unaware of only a few weeks ago.

Some traders think all the publicity has only added to the anxieties that the VIX is intended to reflect. 'The VIX is a self-fulfilling prophecy,' said Ryan Larson, head equity trader at Voyageur Asset Management. 'It's almost adding to the problems.'

Speaking on Thursday 16 Oct 2008, when the VIX hit an intraday high of 81.17 before closing lower, he said: 'You see the VIX trade north of 80, and of course the media starts to pick it up.'

Larson continued: 'It's blasted on the TV, and for the average investor sitting at home, they think, 'Oh, my gosh, the VIX just broke 80 - I've got to go sell my stocks'.'

Put simply, the VIX measures the degree to which investors think stocks will swing violently in the next 30 days. It is calculated in real time throughout the trading day, fluctuating minute-to-minute.

The higher the VIX, the bigger the expected swings - and the index has a good track record. It spiked in 1998 when a big hedge fund, Long-Term Capital Management, melted down, and after the Sept 11 terrorist attacks.

Mr Sachs, with some incredulity, pointed out that the swings in the stock market have reflected the volatility implied by the VIX.

'We had a 17 per cent peak-to-trough trading range this week,' he said last week. 'It should take two years under normal circumstances for the S&P 500 to have that type of trading range.'

The VIX had its origin in 1993, when the Chicago Board Options Exchange approached Robert Whaley, then a professor at Duke, with a dual proposal.

'The first purpose was the one that is being served right now - find a barometer of market anxiety or investor fear,' Prof Whaley, who teaches at the Owen Graduate School of Management at Vanderbilt University, recalled in an interview. But, he said, the board also wanted to create an index that investors could bet on using futures and options, providing a new revenue stream for the exchange.

Prof Whaley spent a sabbatical in France toying with formulas. He returned to the United States with the VIX, which gauges anxiety by calculating the premiums paid in a specific options market run by the Chicago Board Options Exchange.

An option is a contract that permits an investor to buy or sell a security at a certain date at a certain price. These contracts often amount to insurance policies in case big moves in the market cause trouble in a portfolio. A contract, like insurance, costs money - specifically, a premium, whose price can fluctuate.

The VIX, in its current form, measures premiums paid by investors who buy options tied to the price of the Standard & Poor's 500 stock index.

In times of confusion or anxiety on Wall Street, investors are more eager to buy this insurance, and thus agree to pay higher premiums to get them. This pushes up the level of the VIX.

'It's analogous to buying fire insurance,' Prof Whaley said. 'If there's some reason to believe there's an arsonist in your neighbourhood, you're going to be willing to pay more for insurance.'

The index is not an arbitrary number: It offers guidance for the expected percentage change of the S&P 500. Based on a formula, Friday's close of around 70 suggests that investors think the S&P 500 could move up or down about 20 per cent in the next 30 days - an almost unheard-of swing.