How to take the temperature of the markets with the Vix index

The Iran conflict has created considerable uncertainty in the markets for investors to navigate. But how can we take the temperature of the market and compare volatility to where it has been during other periods of turbulence for stocks.

A popular measure used by professional investors is the Vix. You may have seen this referenced in reporting around the current crisis and it is the short name for the Chicago Board Options Exchange Volatility index. The Vix measures expected market volatility implied by option prices on the S&P 500. Options are financial contracts which give someone the right to buy or sell at a certain price at a specific time.

What does the Vix show?

The Vix is expressed as an annualised percentage, so that a Vix reading of 30, (roughly the peak level on 9 March) means investors expect the S&P 500 to move around 30% on an annualised basis.

To convert this into a daily move, the Vix is divided by the square root of number of annual trading days, or 252. This, in turn, equates to 1.9% a day, calculated as 30/15.8.  

For context, the Vix has averaged 19.4% since 1990, equivalent to daily volatility of 1.2%. Interestingly, the Vix almost always overstates actual realised annual volatility by between 3% to 5%.

While the Vix tells you what the market expects, crucially, it does not give a direction. Although historically an elevated Vix has coincided with market sell-offs.

How did the Vix behave during previous periods of market turmoil?

One useful property of the Vix is that it tends to revert to its long-run average over time. This is why some traders look to sell the Vix when it is over 40 (when options are expensive) and buy when it is very low (options are cheap).

An important caveat is that the Vix can stay elevated for prolonged periods like during 2008/9 and 2020.

For example, in March 2020 during the onset of the pandemic, the Vix reached a record 82.69, implying moves in the S&P 500 of more than 5% a day.

The Vix ‘spiked’ over a period of three to four weeks and remained elevated for two to three months.  

Conversely, during the financial crisis of 2007/8 the Vix slowly built over more than a year and remained well above long-term average levels for 18 months.

In conclusion, the Vix is a useful measure of uncertainty which currently implies elevated worry rather than outright fear.

What about other measures?

Another useful indicator is the CNN Fear and Greed index which is a composite measure of seven different indicators designed to gauge the mood of investors.

The measure moved into the ‘extreme fear’ quadrant on 9 March from ‘fear’ the week before and a neutral reading in early February.