Warren Buffet has contributed little to the planet bar income tax. That said though, his deceivingly simple and much quoted line about contrarianism is actually quite well founded.

The VIX Volatility Index (VX) is essentially a measure of uncertainty. When it’s at highs, the inference is that market volatility is also high.  Volatility is caused, at least in part, by investors’ uncertainty that leads to skittishness in their behaviour – often in reaction to rapid developments in the global economic situation. The VIX volatility index enables traders and investors alike to visualise this on a single chart. Ironically, the VIX can itself be volatile, but that’s not important.

The VIX index is calculated using several S&P500 index options. The idea is that options carry a higher premium when there is more uncertainty about the direction markets will subsequently take. This ‘implied volatility’ comes out of investors’ expectations rather than hard statistics, so it’s deemed a useful measure because  investors are human beings and it’s their psychology that drives markets the hardest. The VIX has a high value when future market direction is uncertain (investors might be fearful) and a low value when investors feel confident. The VIX Volatility Index is therefore a useful tool to gauge extremes of market sentiment.

Bull markets are often killed by over-optimism. Many investors fall into the trap of buying at the top of the market. Their reasons for doing so are understandable: buy when times are good! The reason you perhaps shouldn’t buy when times are good is more subtle.

This concept can also be clearly illustrated by thinking about price bubbles. There was a massive technology bubble in the US in 1999/2000 as investors were gripped by mania, leading to vast equity overvaluations and an IPO frenzy. Sure, many made a lot of money, but vast losses were also incurred by those who held the shares until the overvalued companies went bust. Those who made money simply had the right strategy: buy the IPO, then sell later that day when the price rocketed up on high demand. They knew about investor psychology!

Another example. The property bubble in the US, fuelled by hugely irresponsible lending, led to the crash of 2008 – again fuelled by the feeling that prices could only go on rising forever. Many lost a lot of money, but some turned an impressive profit because they knew what was coming just by reading market sentiment.

Conversely, post crisis, when the market was (quite understandably) gripped by fear and uncertainty, the share prices of many of the firms that survived went incredibly low. Those with the foresight to find opportunity in negative sentiment made an absolute killing in the years that followed. Whatever the lot of the likes of Lloyds Banking Group now, if you’d bought shares for 25p a piece 4 years ago, you’d be sitting on a healthy profit.

The VIX Volatility Index or ‘fear gauge’ is negatively correlated with equity indices, so that highs on equity indices (the mania phase) tend to correspond with lows on the VIX (complacency phase). It’s interesting to note that, often, a new major high on the VIX will be followed by an equity market rally. Likewise, a new low on the VIX is often followed by an equity market sell off.

While the VIX is based on the S&P500, it does also bear a relationship with equity indices in general – especially those exposed heavily to the US Dollar like the UK’s UK 100 . Note UK Index reversed from its YTD low, which corresponded (to the day) with the VIX making YTD highs i.e. indicating heightened fear in the market. Clearly, like in the aftermath of the financial crisis, when there was a lot of fear, a good portion of the market started buying and got good prices as a result.

While these things are never 100% correlated, any indicator you can use to give your trading strategy a positive edge – like the positive edge casinos and bookies enjoy that they know will make them money in the long run – should be in your analysis arsenal.  Importantly, the relatively unsophisticated investor can also use indicators like the VIX Volatility Index because all you need is the number. Once you’ve pinpointed a trade or investment idea, have a quick look at the VIX and see if it supports your view.

For educational bits and bobs relating to other market indicators, visit our Education & Strategies page (click here).

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Augustin Eden, Research Analyst