The Volatility Index - VIX

Advice from Warren Buffett includes being greedy when others are fearful. So something known as the stock market’s “Fear Gauge” is probably worth keeping an eye on. This gauge is the Volatility Index, the VIX.

The short version of the VIX, is that it is a barometer of expected market volatility based on S&P500 options pricing over the next 30 days. This information is condensed into a single number, which tends to spike upwards when the markets get volatile and unstable.

The VIX was created by the Chicago Board Options Exchange (CBOE) in 1993. It’s initial formulation was based on S&P100 options pricing. In 2003 it was revamped to be based on the S&P500, and tweaked again in 2014 to provide the version of the VIX used today. The CBOE have a white paper describing the VIX calculation and step by step guide here.

As usual there is a bit of unpacking required to really start to get understand what the VIX tells us.

 Options

Options are a way of protecting investments from the movements of the market. Purchasing an option gives the holder the right to buy or sell an investment at a pre-agreed price – no matter what price the market currently has for that investment.

“Calls” and “puts” each can be used to protect from price increases or decreases. A “call” is used to buy at a pre-agreed price, so the holder of a call option is protected against the price of an investment increasing, which would allow them to buy at a price lower than the market. A “put” is used to sell at a pre-agreed price, so the holder of a put option is protected against the price of an investment reducing and allows them to sell at a price that is higher than the market price. Each option has a lifespan, after it’s expiry the option cannot be used.

Of course the protection offered by options comes at a price, and the demand for protection drives that price. If there is widely held view that the price of a certain share is likely to drop significantly then the cost of taking out insurance against that fall though buying put options is likely to increase. 

Those option price movements reflect the anticipated movement of the underlying share prices. Using the analogy of an insurance premium, if two very similar people are paying very different amounts for their car insurance, the difference in price is likely to reflect the risk perceived by the insurance underwriter. In other words, price can be used as a proxy for risk.

The price of options and the movements of those prices are what drives the VIX. The options in question are those which relate to the price movements of the S&P500 expiring in around 30 days (specifically between 23 and 37 days in the future). As people buy and sell options the prices move, the more they move, the more the VIX will increase. The VIX takes an average of these movements and condenses these into a single number.

Volatility

According to the VIX white paper: “the VIX index measures 30 day expected volatility of the S&P500 index”. The volatility is the price movements of S&P500 options, which represents a crowd-sourced indication of the belief that the S&P will increase or decrease in value at various points in time in the next 30 days. Although the VIX is described as the “fear gauge” it is not simply falling prices that drive the VIX, upwards price movements also contribute. It is also not historic, but future, predicted movements that drive it – also known as “implied” volatility. For once statistics has a useful term to describe this – the variance of the prices, both up and down, from an average. The wider this variance gets, the lower the certainty over where markets are headed, and the higher the VIX will be.

Interpretation

The relation between the S&P and the VIX can easily be seen in a few charts here via googlesheets, it shows the S&P500 and VIX values over 3 different time-frames, and a scatter-plot of the same. The trend line of the scatter-plots shows a clear negative correlation between the two. Below is an example of the data from 2005 to 2020:

VIX and S&P500 2005 - 2020

As noted above the VIX is a statistical representation of the prices for S&P500 options, more specifically percentage price movements. It is a figure that is annualised - meaning it represents a range of variability for the next year. So if the VIX is at 20, it indicates that the S&P500 is expected to see a range + or - 20% from it's current point over the next year... most of the time. "Most of the time" here is specifically 68% of the time - this is due to some of the stats in the calculation (it represents one standard deviation). If we are to believe the stats, then for the other 32% of the time we should expect the index to be trading outside of this range.

So as we can see, when the VIX spiked up to over 80 in March, this effectively says that we collectively had no idea where the market was headed. The complete lack of certainty had people buying and selling insurance premiums like crazy, forcing the VIX higher. Over the 6 months since then, as people have become more comfortable, the demand for insurance in the form of options has eased off, and so has the VIX.

As a non-trader my interest in the VIX is rather academic, but it is a fascinating construct. I suspect it won't remain dormant for long given the multiple market risks on the horizon...

July 2020 portfolio update

I find watching the virus headlines come and go a bit dizzying after a while. But hearing Google pronounce that they don't expect to get people back into the office for another 12 months got my attention. 12 months...?

Over the last month US stocks have been pushed up by the trillion dollar tech companies, elsewhere they have been down. Europe saw spread of the virus start to pick up after it's lock-down, and the US saw it's cases explode. Probably a useful experiment as to the effects of not implementing adequate social distancing. This, plus an increasingly creaky relationship with China, and an election in a few months has seen the Dollar weaken. Trumpy went particularly strange at the end of the month deciding that the November election (the one that hasn't happened yet) won't be legit thanks to voter fraud...

There has been a bit of movement in share prices as businesses have delivered trading updates, which has resulted in some of those on my shopping list getting back to more inviting prices. A few companies have demonstrated a great deal of resilience. Good companies temporarily having a bad time could be a great investment, providing those tough times reverse before any long term damage is caused. Those companies showing resilience - these are the businesses I really want to own, but their prices are high... For this month, nothing too exciting I've topped up the Asian investment trust I bought into in June.

Portfolio performance
The portfolio was up +1.3% in July, ahead of my chosen benchmark (Vanguard FTSE All Share Accumulation) which was down -3.6% over the same period.

Best performers this month:
Dignity +31%

Computacenter +21%

Somero Enterprises +10%

Worst performers this month:
Fulcrum Utilities -12%

National Grid -9%

Glaxosmithkline -7%

July share purchase: HFEL

A top up of Henderson Far East Income Investment Trust (HFEL) was the only activity for the portfolio this month. I bought into this last month - there a few details on HFEL in my June update.

The Trust increased it's quarterly dividend by around 1.5%. In "normal" times this wouldn't get much attention but given the current environment it did cause one of my eyebrows to raise. The argument from the Trust is that most Asian economies went into the COVID-19 crisis healthy, and has managed it's response relatively well, so they expect them to come out in better shape than most other areas. And the specific companies in which they are invested have decent cash flow so should see relatively limited damage to dividend payments. There are around 9 months of reserves that the Trust can use to cover any shortfall and smooth out the dividend payments. I would have preferred them to err further towards caution and not increase the dividend, instead building up the reserves, which could then contribute to more aggressive increases on the other side of COVID-19 if they weren't needed.

However, the confidence of the Trust's Board and managers that they could at least continue the current dividend payments were enough to encourage a top up. I do wonder if this is a little bit of marketing, trying to pinch a few customers of other income based Trusts that may have a tougher time with dividends, time will tell.