October 23, 2008
Analysts’ favorite measure of expected stock market volatility and investor anxiety, the Chicago Board Options Exchange
Volatility Index, known as the CBOE VIX, hit an intraday fresh high when it briefly topped 96.40 percent Thursday, Oct 23. The VIX eventually closed at 67.80 percent. Its highest close of 70.33 percent was set on Friday, Oct 17.
The market continued to search for a bottom with S&P 500 dove sharply below 900 points Wednesday, ending at 896.78, while the Nasdaq finished at 1615.75. On the same day, S&P 500 and Nasdaq closed at five-year lows; thought the S&P bounced back to 908.11 at Thursday close.
On Wednesday the Dow Jones Industrial Average dropped 5.7 percent, which was its seventh biggest point drop in history. Of the top 10 drops, four have occurred this month. The Dow is now off more than 5600 points, or 40 percent, from its October 9, 2007 high of 14164.53. The Dow rose 2.02 percent to 8,691.25 on Thursday.
Based on statistical formula, the VIX highest close of around 70 suggests that investors expect the S&P 500 would swing up or down about 20 percent over the next 30-days. The figure implied a chaotic outlook for the next 30-days.
Until recently the Dow has still swung more than 500-point or 5 percent range on daily basis and 21 percent over the past week. The S&P 500 had also experienced monstrous sways of a 17 percent trading range in the past week. The large swings in the stock market over past weeks have reflected the volatility implied by the VIX. Extreme market volatility remained the dominant feature as stocks were hammered by both fears of deep economic recession and hopes the financial crunch is finally starting to ease following dramatic government and central intervention in the banking system.
The VIX was as low as 20-25 percent right through August. It started to accelerate after a shakeup of Wall Street that took out two storied names, Lehman Brothers and Merrill Lynch, Monday, Sept 15. The subsequent wave of sell-offs in stock markets has sent the VIX to 46.72 close mark Monday Sept 29, passing its previous high. The wild swings in stock market since the beginning of October have propelled the VIX to its current unprecedented high.
While the VIX is known as a key measure of market expectations of near-term volatility conveyed by
S&P 500 stock index option prices, the volatility index is often referred to as the "fear index” in the stock market.
The VIX calculates the expected stock market volatility for the next 30 days. The indicator accomplishes this by using a weighted average of implied volatility from premium of options contracts on S&P 500 index.
In times of confusing and fear on Wall Street as the value of S&P 500 stock index lost, investors are scrambling to pick up options in order to hedge against those losses. In other words, as investors are fearful that the S&P 500 is going to have more large swings over the next two months, they are buying protection against losses and paying more for put options contracts. That, in turn, drives up option prices, as well as the VIX. Consequently, the higher the fear levels, the more the volatility index rises.
Be greedy when others are fearful?
The VIX is also a
contrarian indicator. Some believe that peaks in the VIX are closely associated with market bottoms. That's because climaxes of fear are times when everyone who's ever going to sell has sold. And when all the sellers are out of the way, the buyers have the field all to themselves.
Typically, a VIX level above 40 is considered a sign of fear. Given that the indicator is at record levels, it is essentially calling for a forthcoming rally. This is partially why some market observers believe that now is a buying opportunity for investors.
Market analysts have been racing to call a market bottom in recent weeks as stocks have shed more than 30 percent of their value from the highs of a year ago this month. Volatility Index skyrocketed past 80 last week, more than double the normal mark for a level of market anxiety.
Long-term investors, who can see further horizon and can tolerate withering day-to-day volatility, started getting back in the market. In an opinion column of New York Times on Friday, Oct 17, billionaire investor Warren Buffett said he was now buying U.S. stocks. “A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful," Buffett wrote in the paper. “What is likely...is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up," he said. "So if you wait for the robins, spring will be over”.
Buffett is obviously giving people the right advice about investing, that you need to take a long-term view and that at times when everybody assumes the worst, it's usually the best time to buy.
If history is any guide, investors could get a perspective from VIX earlier highs. Take a look at the peaks of the VIX in the previous global financial crises of October 1997, when the hedge fund Long-Term Capital Management collapsed in October 1998, and in the last bear market in October 2002. They were all terrific buying opportunities.
It’s unquestionable that the unprecedented VIX high has provided long-term investors with important indication and direction of where the market may be heading in these times of confusing and anxiety on this most vexing financial crisis and market turmoil.
Nevertheless, just because the VIX is rising sharply doesn't mean that it can't keep rising. People may get even more fearful in the months to come, and market may slide further. Investor should be aware that real economic problems would continue for the foreseeable future. The current problems facing the financial sector dwarf the LTCM debacle and Enron-WorldCom-Tyco book cooking that had led the volatility index setting its previous highest levels in 1998 and 2002.
Though the freeze on credit is starting to thaw, short-term credit remains very difficult to secure. More jobs will be shed and an unemployment rate in the high single digits is within the realm of possibilities. Consumers are tightening their budgets. A higher number of home foreclosures and credit defaults will occur. Demand for exports will be weaker in the months ahead.
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