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What Do They Mean "Volatility"?

Written by Briton Ryle
Posted May 10, 2017

If you pay any attention to the financial media, like CNBC or Bloomberg, you've probably heard some smarty-pants talk about volatility, the Volatility Index, the VIX, or the Fear Index.

And the thing about a smarty-pants is they don't like to actually explain what they're talking about. Because clearly, explaining jargon, or even just using plain language, is very un-smarty-pants like.

You're just supposed to know.

So, don't expect CNBC to ever give you a reasonable or useful definition of the Volatility Index.

Instead, they will continue to allow you to bask in smarty-pants wisdom like this shiny little nugget from a Société Générale strategist: "The risk is plain — super easy monetary policy is creating artificially low volatility and driving money into trades and investments that are mispriced as a result."

Umm... WHAT?!

But today, you're in luck! Because I am pretty much the opposite of a smarty-pants. In fact, most people that know me will tell you I'm not smart at all. (Hey, wait a minute...)

So, I don't mind talking with you about the Volatility Index in plain language. And I'll start with two things.

First, volatility, the Volatility Index, the VIX, and the Fear Index are all the same thing.

Second, it doesn't "mean" anything.

What Is the Volatility Index?

The Volatility Index trades under the ticker symbol VIX. That's why they call it the VIX. The VIX measures the premium, or price, of put options on the S&P 500 index. I know, I looked it up...

Now, a put option is a downside play on a stock or index. You buy a put option on, say, Apple, and if Apple falls in price, your put option will be worth more money. (Strategy advice: don't buy put options on Apple.)

Put options are often thought of like insurance. It works like this: Say you own $1 million of Apple stock (congratulations!). You could put down $10 grand and buy some put options.

That way, if Apple shares sell off 10%, those put options might be worth $50,000 or $60,000. You could then sell them, and you've offset a good portion of your losses on Apple.

And if Apple doesn't sell off, well, at least you were protected.

Most individual investors don't use put options to ensure or "hedge" their portfolios. But big money managers do.

If you're running a $500 million mutual fund and your bonus is tied to your performance, you might want to spend a little money to protect your portfolio from a downside move. One common way money managers protect their portfolios is by owning put options on the S&P 500.

But here's the thing: Money managers don't always own a lot of S&P 500 put options. They tend to try to pick their spots.

So, when they think the market is getting risky — like, say, before a Fed meeting or ahead of an important event like that Brexit vote last year — they may buy put options. You know, just in case.

Now, here's a funny thing about options prices: They aren't fixed. Just like with stocks, when a lot of people start buying certain options, the prices rise. This change in price is known as the "premium."

So, when a bunch of fund managers sees risk for the market, they start buying S&P 500 put options, and that pushes the premiums higher.

That's what the VIX measures. It's called the Fear Index because people think it tells you when the "smart" money is afraid of a sell-off.

I hope that all makes sense to you. Because this next part can get a little confusing, at least to me...

Mainstream Contrarian

The ironic thing about the VIX is that it's considered a contrarian indicator. There's even a little Wall Street nursery rhyme about it: "When the VIX is low, it's time to go. When the VIX is high, it's time to buy."

The idea is that when the VIX is low — because no one is buying S&P 500 index put options — investors are underestimating risk, and that's exactly when the risk is highest.

vix 23 year

In a general sense, yeah, investors tend to be unprepared for a crisis.

If you look at the last two major bear markets — after the internet bubble popped and the 2008 financial crisis — investors were generally very bullish right up to the point that it all fell apart.

Conversely, investors tend to be very bearish at market bottoms.

I know, shocking insight, right?

Right now, the Volatility Index is below 10, at a 23-year low or something ridiculous like that. And the smarty-pants crowd is freaking out because no one sees the imminent stock market crash coming.

Or, to paraphrase the smarty-pants strategist guy earlier: Loose monetary policy has created a stock market bubble, and no one sees the risk.

It seems pretty clear to me that investors don't see much risk right now.

Stock prices have ramped since the election.

We've priced in a lot of good news on tax cuts and infrastructure spending that hasn't happened yet. What if neither of them happens?

Nobody expects rate hikes to really affect the economy, but they certainly could.

For starters, higher interest rates mean the federal deficit gets more expensive. And I'm particularly concerned about what a stronger dollar could mean for emerging market companies.

em dollar debt

When a foreign company sells dollar-denominated debt, the debt gets a lot more expensive to pay off if the dollar rallies.

I can see a vicious circle here: foreign companies have to buy dollars with local currency, profits shrink, threat of default, local currency weakens more so debt gets more expensive, etc.

There's the ever-present threat that China will lose control of its economy (though with the National Congress coming later this year, I'd think China would do everything possible to maintain the status quo).

Now, all of these things are worth worrying about, but not because of the VIX.

The VIX doesn't make the Fed more or less likely to raise rates. The VIX will not force Congress to pass tax cuts. It doesn't work like that.

All the VIX does is tell you that big investors are not preparing for a market sell-off right now. That's it.

But also don't forget that, as this one guy I follow on Twitter likes to say, "Risk happens fast."

Until next time,

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Briton Ryle

follow basic@BritonRyle on Twitter

An 18-year veteran of the newsletter business, Briton Ryle is the editor of The Wealth Advisory income stock newsletter, with a focus on top-quality dividend growth stocks and REITs. Briton also manages the Real Income Trader advisory service, where his readers take regular cash payouts using a low-risk covered call option strategy. He also contributes a weekly column to the Wealth Daily e-letter. To learn more about Briton, click here.

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