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VIX: Index of fear, complacency or ignorance?

Here we go again. More gumpf last week about the precipitous decline of the VIX and how the "Index of Fear" has gone down to seven-year, pre-crisis lows.

Maybe if I say "Index of Fear" enough times I can convince myself, and anyone reading this column, that it is a big, scary concept that really is so terrifying we should all run for cover when it ticks up or that we are set for eternal peace when it continues lower.

Traders work in the Volatility Index Options (VIX) pit on the floor of the Chicago Board Options Exchange (CBOE) in Chicago, Illinois, U.S.
Tim Boyle | Bloomberg | Getty Images
Traders work in the Volatility Index Options (VIX) pit on the floor of the Chicago Board Options Exchange (CBOE) in Chicago, Illinois, U.S.

The truth is that the VIX is not an "Index of Fear" and never has been. It's a plain old measure of premium. Premium in option products that are a derivative of the equity market. A market which, apparently is at, or near, all-time highs in many cases.

As any option trader will tell you: Pretty much most of the time when markets go up, the volatility goes down and vice versa. The VIX DOES NOT lead the equity market, it follows it.

I also read it is so low because either everyone is bullish about the stock market or they are being ridiculously complacent about the downside risks. Maybe this is part of the story but there is a bit more to it.

Volatility indicators, of the which the VIX is just one, are also at such low levels not because everyone who is in the market is so complacent but more likely that they are so desperate. Desperate that is not to spend any money on downside protection because they are struggling to make money out of the multi-year rally in markets.

The truth is, as I have written before, so many money managers from hedge funds to pension funds have underperformed the indices they are investing in. Underperformed plain old vanilla longs. So the logic goes that if they then have to start paying out premium for protection this will further hit, what is in many cases, a pathetic performance.

In addition, with the ECB looking like it's throwing in the towel and set to pump the markets further, who in their right mind needs downside? Yeah right, good luck with that one.

One more reason for low volatility/VIX lies in the structure of the market players themselves now. Our good old friends the "algo" traders using high-frequency trading strategies jump on any movement in underlying stocks at the first opportunity.

The VIX is ultimately a measure of insurance. But too many potential players are being put off by the fact that, if the underlying equity market goes up, stays the same or even goes down a little, buying it is a lossmaking strategy. What a shame that most long players are still in the dark about how the VIX, volatility and options can boost their current meager returns.

Still the dark is a place of fear. A whole 'Index of Fear'.

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