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VIX And Passive Investing Risk

The CBOE volatility index® VIX® is an instantaneous measure of expected fluctuations in S&P 500 in the next 30-days. This is an instrument for short-term traders. Passive investors should use different measures of risk. I offer an example.

Up-to-the-minute calculations of VIX provide an estimate of how the market thinks the S&P 500 will fluctuate in the next 30 days. This estimate constantly changes.

VIX fell recently to levels seen during the 1990s and 2000s uptrends. This means that the market thinks that in the next 30 days volatility will be low. However, this number can change at any time. VIX is another measure of risk for position traders based on implied volatility of options. Last values of VIX are not useful to passive investors and do not measure their risk.

For example, VIX closed at 9.75 on Friday. This means that the market estimate of the expected fluctuations in S&P 500 of the next 30 days based on options bid/ask spread is 9.75%. Is this a useful number to a passive investor? Absolutely not, since it is a short-term measure of implied volatility.

Below is a VIX chart with a different measure of risk.

The first pane shows occurrences of the VIX intraday low below 9.60. It may be seen that those occurred during the 1990s and 2000s uptrends. Therefore, very low VIX levels occur during strong uptrends.

The second pane shows the percent change from a 252-day close. This is a different risk indicator based on realized volatility. Largest drop was -52.6% and occurred in 2008. If a drop of this magnitude has already occurred, why should we assume that it will not occur again?

A more important observation is that VIX rarely provides a warning about a large market drop. Its value as a leading indicator is overrated. Therefore, only historical values of VIX can provide estimates of risk for passive investors. Deciding to go passive because VIX is now low is based on the wrong interpretation of this indicator. But passive investors do exactly the opposite of what they are supposed to do: they buy when VIX is low and sell when it is high instead of the reverse. Apparently, the financial media is a major source of this confusion because they have called this the “fear index” instead of a more representative term, such as “market calmness index”.

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Charting and backtesting program: Amibroker

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