Using the Fear Gauge
26 May 2017
What if there was a way to measure expectations of variance in the market? What if we could measure how investors attitudes are based on current market conditions? It would be pretty handy if we had a way to determine what the “temperament” of the market is. While we don’t have the ability to survey all investor’s feelings, we can use a proxy based on the expected volatility of the S&P 500. This is the VIX Index, or what is commonly referred to as the Fear Gauge.
What makes up the VIX?
Started in 1993, the VIX Index is calculated by using the pricing on options for the S&P 500. The idea is that movement or volatility in the markets can be measured using the pricing on underlying options strategies. As the S&P 500 moves up or down in wide swings, traders pay more to establish their positions. In general, a VIX Index above 30 is considered volatile market with a lot of variance in price. Anything below 20 is considered a relatively tame or calm market environment.
Why the Fear Gauge?
The term Fear Gauge came about because of what the VIX Index is measuring. Because is it measuring short term variance in price, a high VIX score means there is expected to be a lot of movement in a short time frame. This is typically due to uncertainty or “fear” in the market. Contrast that to when the VIX Index is low, it is typically associated with relatively calm financial markets.
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Why does this matter?
Depending on your investment horizon, it probably doesn’t. Especially when we are looking at a long term investment time horizon, the current VIX Index score plays very little into our investment decisions. Our process lends it to looking at the long term, meaning a period of 10, 15, even 30 years. Not 30 days as is anticipated to be indicated by the Fear Gauge. Making multiple trades based on short term market swings is not investing. This is speculating.
The next time that you hear someone yelling at the top of their lungs about the VIX, remember what it is measuring. This is looking at anticipated short term variance. Keep in mind they are probably attempting to time the markets with short term trading. Our goal is to build wealth over the long term by controlling the things that we can. Not throw our money into a casino with the hope that we are right this time.
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