Beware of the VIX "Fear Index"

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The VIX Index, more commonly referred to as the Fear Index has begun to make investors (more) nervous this week. On Monday, 13 October, Erin Gibbs of S&P Capital told CNBC that, essentially, anxious investors need to remain calm because “Volatility is still within normal levels,” even though fellow commentator Todd Gordon warned that if the VIX surged upward past 20, investor anxiety might be warranted.

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Although she somewhat agreed with Gordon, Ms. Gibbs indicated that she really didn’t expect the VIX to move much off the 20 mark in either direction. Ms. Gibbs was wrong. Today the Fear Index hit 30, the highest it has been since December 2011, indicating a strong potential for increased volatility in the markets.

Very few people understand how the VIX is calculated, but that is not the point. The point is that almost everyone who watches the VIX, regardless of what they understand about it, tends to have a emotional reaction to it. It might be fair to say that the VIX reacts emotionally, or anticipates investor emotional reactions, to market activity.

To put it another way, someone once said that if the VIX goes higher than 20, everyone starts playing Chicken Little. Even if the sky is falling.

The VIX lies somewhere between perception and mathematical reality. It is a realistic eyebrow raiser, but it can’t be regarded as highly accurate. In fact, as any index does, it lags somewhat behind market activity because it is measuring market activity.

As millions of transactions take place, the VIX calculates a number derived from the weighted average of option prices in the S&P 500. When the VIX is at 20, for instance, it is telling us that we can expect that the S&P to rise or fall plus or minus 20% over the next 12 months slightly more than two thirds the time. Today it is telling us that we can expect a 30% plus or minus variation in the S&P 68% of the time over the next 12 months.

The index has remained around the 15 mark over the past 12 months, so when it jumped to 20 for the first time since January that began to rattle some cages. On 19 September the VIX was at 12.03. By 08 October it had climbed to 15.11. It continued to escalate daily, reaching 24.64 on the 13th. That is when the VIX began making headlines. At approximately 1:30 p.m. EDT today it nearly breached 31, hitting 30.88 before tailing off.

One caveat: The VIX would have changed significantly as shares of Shire plc (LSE:SHP) were hit hard in trading today.

Nonetheless, we should take note that the Fear Index is higher than it has been for nine months. The question is, “At what point does your fear index kick in?”

 

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