VIX, or volatility index, measures the volatility of the S&P500 index’s options and is commonly referred to as the fear index. In this brief overview, we’ll look at what insight it can give us.
In the current times, almost every day news regarding the uncertain (and often negative) future of the economies across the world can be read. One day it’s the inflation rate, the other it’s the war in Ukraine and its implications, and so on and so forth. However, news like these aren’t “new”. For a really long time now, and especially after COVID-19 began, negative news has been at the forefront. One could argue, how couldn’t they? After all, before the pandemic started, the world as a whole recorded one of the best decades for growth in a long time. As such, it’s easy to see things as more negative after the pandemic started, as in relative terms, the world “seemed” like a better place to live before the pandemic.
Now, so much news of this kind has been around, from the aforementioned high interest rates, and wars, to specific countries (in both Europe and the Americas) having the worst performance in a while (some of them even dubbed “the Sick Man of …”). After a while, it would seem that this negativity has almost of a “numbing” effect, and news that would cause a market deterioration, like interest rate hikes, and large natural disasters associated with climate change, don’t seem to have that major of an effect. After all, after hearing a similar thing over and over again, even if each of these things by themselves could have negative consequences, people get tired of hearing them.
This could be an approximation of what is happening right now on the market, and why the market sentiment despite all the negative news does not seem to be as affected. Furthermore, despite all of this, there seems to be hope that the situation might improve soon. This brings us to the volatility index, or VIX, also known as the fear index. It is called that as it measures the volatility of the options on the S&P500 index, meaning that in a sense, it measures the sentiment on the market and the expectations for the future. As such, by extension, it could be used as a proxy for future market movements. After all, in majority of the cases, if people believe that something will increase or decrease, the market tends to go in that direction, especially in the medium to long term.
Volatility index (VIX) performance (2013 – 2023 YTD)
Source: Bloomberg, InterCapital Research
Currently, the volatility index sits around 18.6 points, with the higher the number implying higher volatility. For example, at the height of the Global Financial Crisis of 2008, the volatility index breached 79 points, while at the beginning of the pandemic, it reached 66 points. If we look at the graph, indeed we can see there is a lot of volatility, however over the last 10 years, the index averaged at app. 18.1 points. Before the pandemic, it averaged an even lower 14.9 points. What can this tell us? The current market sentiment, despite all of the things that are going on, is generally positive. That the expectations for the future, are also quite positive. Quite a turnaround from all the doom and gloom we have witnessed in the last couple of years. Especially if we consider that the interest rates in the US, but also Europe and across the world are at really high levels, especially compared to what they were before. If we add the geopolitical situation into the mix, one would expect a lot more volatility and a lot more fear to be demonstrated on the market. And even though there are periods when that is the case, such as when news that oil production has been cut, or the war in Ukraine has escalated to a new level not before thought to be possible, like an elastic band, the sentiment returns to pretty much the baseline.
Meanwhile, as expected, the negative correlation between the VIX and S&P500 is quite high, at -0.7, meaning that a decrease in the VIX, leads to an increase in the S&P500 index. Has this been the case? Over a longer time period, and in this sense years, it wouldn’t make sense to compare one to the other even with this negative correlation, as there are many many things that can influence the sentiment on the market and thus skew data. In the shorter time frame, in which the sentiment could be more easily gauged, it could be argued that the comparison can be made. For example, on a YTD basis, VIX declined by app. 19%, while in the same period, the S&P500 increased by 11.5%. This makes sense. Better sentiment on the market -> more people willing to invest -> growth in the index.
So maybe the summary that could be taken away from this is, that no matter how negative the news might seem, it feels a lot more “real” in the moment. Furthermore, over the longer time period, despite all the negativity, there is still positivity left as well, even in an abstract form such as the index that tracks options.