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What everyone gets wrong about the 'fear index'

Sam Ro
Managing Editor

The CBOE Volatility Index (^VIX) is so low that some market watchers worry that complacency is dangerously high in the stock market, making it unusually vulnerable to violent sell-offs.

Also referred to as the “fear index,” the VIX reflects the premium that options traders pay for protection against big price swings. When the VIX is high, fear is thought to be high. And when the VIX is low, the opposite is thought to be true.

Some investors will go a step further and argue that an elevated VIX reflects an opportunity to buy stocks. Conversely, some also argue that an unusually low VIX is a sign of trouble to come, which means low or even negative returns.

(Source: Flickr/Eugene Zemlyanskiy)

Unfortunately, there isn’t much historical data to support the idea that a low VIX is bearish.

“The misrepresentation of the VIX as a fear gauge signaling future market weakness is just plain wrong,” Citi’s Tobias Levkovich said in a note to clients on Friday. “Widely available indicators provide little investment ‘edge’ even if the consensus narrative is overly focused on this volatility metric despite its poor predictive power. Indeed, the S&P 500 has been higher 84%-88% of the time 12 months later when VIX readings were between 10 and 20 or between 30 and 40; hence, low or high VIX levels are not nearly as useful as advertised.”

Low volatility is not a sign of imminent trouble.

For years, Levkovich has argued that the VIX is “wildly misunderstood.”

“Yet, there is a constant drumbeat about this ‘fear gauge’ that does not generate the kind of fearful declines that are being advertised,” Levkovich said. “In our minds, data trumps opinion…”

So, while a low VIX reflects a low premium for protection against market volatility, it does not necessarily reflect a bearish level of complacency. Rather, the opposite seems true.


Sam Ro is managing editor at Yahoo Finance.
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