The Cboe Volatility Index, with the ticker symbol VIX, is a standard risk indicator used by financial traders.
The VIX is also known as the stock market fear gauge index.
How does the VIX work as a risk indicator?
The VIX is calculated using a formula to derive expected volatility by averaging the weighted prices of out-of-the-money puts and calls.
Bearish or pessimistic investor sentiment is represented in the options market by investors taking output options, which is a contract, a derivative giving the option buyer the right, but not the obligation, to sell—or sell short—a specified amount of underlying stocks by given expiry date.
So when an option trader buys puts, they are anticipating profit from falling prices.
Conversely, when option traders buy calls, they are anticipating profit from the rising prices.
The sum of all the call options divided by the sum of put options, in a given period provides a number, which is called the VIX.
How to read the VIX as a risk indicator
The VIX, fear risk index, indicates the level of stress in the stock market.
So, the higher the VIX, the greater the level of fear and uncertainty in the market. As a simple rule of thumb, in the past few years, if the VIX value is lower than 20, the market has been relatively stable. Yet, if the VIX value is higher than 30 or more, the market volatility is high, and the investors have to be extra careful with their decisions.
So February 2020, was the start of the pandemic. The VIX value was at 13.68, which is relatively low, and reflected the mood of the time, where investors were anticipating that financial markets would remain stable and likely had an optimistic outlook. Then came the global lockdowns in March 2020, the VIX value had risen to 66.07, which indicated investors have a high level of fear and stress in the market. At the same time, the S&P index declined 1000 points, a drop of over 30%.
The VIX risk index is a tool to protect capital and even profit from chaos
So, in early May, I wrote a piece entitled, Univestable Markets, on the basis that inflation was not temporary as being peddled by the Fed. Moreover, the Fed’s attempt to fight inflation would ultimately burst the everything bubble, which it partly created.
So, this view structured in a trade would be to raise cash, preferably kingpin dollars, let it crash, then buy the dip as the Fed eventually pivots. Alternatively, if investors decided to hold their stock positions, not wanting to realize a loss, they could hedge to protect their capital by buying the VIX. The VIX is up over 50% since May.
Another risk indicator, with more factors in the equation yet easy to read
Keep the MMRI Market Risk Indicator on your radar. I think it has value.