The Fear Index Explained

  • May 30, 2020

How volatile and anxious is Wall Street amid this potential global pandemic that could bring the global economy to its knees? We need to look no farther than the Fear Index explained as VIX. 

The Fear Index Explained

The VIX is perhaps one of the best gauges of deep-rooted concern in the market and one of the most closely watched measure of market volatility.

Why Is the VIX Called the Fear Index?

  • Most, if not all, traders have heard of the VIX. But but did you know it was called the fear index? Volatility moves markets. And fear causes that volatility. If you don't know when volatility is going it hit, it can be detrimental. As a result, having a fear index and knowing how to read it is extremely helpful. 

1. What Is Volatility and Why Is It Important?

Put simply, volatility is a statistical measure of the degree of variation in the trading price of a security (i.e. stock) over a specific time period.

Likewise, the more dramatic the price swings are in that instrument, the higher the level of volatility, and vice versa. Although volatility can keep even the calmest of investors up at night, it can be a day traders dream.

As you know, day traders - scalpers especially, thrive on short-term price swings. A 1000 shares at $0.20 profit here and there, adds.

But these swings aren't going to happen unless there's a trigger. Without a trigger - like mass panic due to a virus, there are no swings. With no swings, there's no money to be made.

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2. A Bit of Background on the VIX

The brainchild of the Chicago Board Options Exchange (CBOE), the VIX is a real-time market index that represents the market's expected volatility in the coming 30 days.

Using price inputs of the S&P 500 index options, it provides us with a measure of market risk and investor sentiment.

You might have also heard it referred to as the "Fear Gauge" or "Fear Index," and it's considered to be the leading indicator of the U.S. stock market.

The Fear Index explained is covered in our live trading room. We use it in tandem with what stocks we want to trade.

3. What Does a Low VIX Mean

When the VIX is low, SPX options are cheap, because traders are expecting very little volatility in the next 30 days.

 And since stocks tend to fall a lot faster than they rise, it can be assumed that when traders expect low volatility, they expect stock prices to rise.

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4. What Does a High VIX Mean?

Basically, when the VIX is high, it means options traders expect a lot of volatility, and therefore falling stock prices. What this translates in to is people paying a higher than the normal premium to protect themselves against a downward move in stocks.

So it's very simply a really accurate measure of the amount of fear being expressed at that moment by options market participants.

The index can be used in contrarian investing, according to the old adage "buy when there's blood on the streets "... as long as you're sure there's not going to be more blood on the streets tomorrow, of course.

As the say goes, buy the dip but don't try to catch a falling knife. Otherwise, it's going to be your blood on the streets.

What Does the VIX Mean: The Fear Index Explained

  • The fear index is also known as the VIX. So what does that mean? The VIX is also known as the volatility index. As a result, since traders thrive on volatility, this is a way to measure it in for stock market trading

1. How We Use the VIX or the Fear Index to Make Investment Decisions

Before making investment decisions, many look to the VIX as a way to measure many things such as market risk, fear and stress before they take investment decisions.

In absolute terms, VIX values greater than 30, reflect large volatility because of increased uncertainty, risk and investors' fear. Alternatively, VIX values below 20, generally correspond to stable, stress-free periods in the markets.

2. You Can Trade the VIX - Sort Of...

Like all indexes, one cannot buy the VIX directly. However, we know, money's to be made in volatile markets. CBOE realized that if they could capture volatility and package it into a tradable product, they could make money.

And deliver it they did. In 2004, we saw the creation of the first VIX-based exchange-traded futures contract. Shortly after that, VIX options were launched, paving the way for users to utilize volatility as a tradable asset.

Many active traders, large institutional investors and hedge fund managers use the VIX-linked securities for portfolio diversification.

History demonstrates a strong negative correlation of volatility to the stock market returns. In other words, when stock returns go down, volatility rises and vice versa.

Are you interested in getting into the game? Why don't you check out ProShares VIX Short-Term Futures ETF (VIXY), or iPath Series B S&P 500 VIX Short Term Futures ETN (VXXB)?

3. The Fear Index Explained and COID-19

So, the underlying question remains: How nervous are investors considering we are in a pandemic? NERVOUS.

If you recall, 2008 brought the financial market to its knees thanks to the proliferation of esoteric mortgages and derivatives. On November 20, 2008, the VIX fear factor hit a historic peak of 80.86. Overall, the VIX soared 108% for the year. And what followed? The 2007-2009 recession.

the Fear Index

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Compared to the VIX move in 2008, the movement this year is dizzying. In fact, the CBOE VIX boasted a nearly 300% year to date return on March 3, hitting it's highest intraday level since 2008.

4. Key Takeaways of the Fear Index Explained

  • The CBOE Volatility Index, or VIX, is a real-time market index representing the market's expectations for volatility in the next 30 days.
  • We use the VIX to measure the level of risk, fear, or stress in the market in order to make investment decisions.
  • Day and swing traders can also trade the VIX using a variety of instruments such as options and exchange-traded products.
  • A high VIX indicates pessimism by option traders
  • The more panic in the market, the bigger the VIX spike. So if the market has a sudden drop in an hour, the VIX likely will spike.

The Bottom Line on the Fear Index Explained

When the VIX rises, stocks prices decline because traders and investors use it to hedge their equity positions. And with the VIX continuing to soar, the economic uncertainty continues. But we know uncertainty brings volatility and volatility means money is to be made. As far as where the VIX is going to go, it's anyone's guess.

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