Systemic Risk and the VIX

As many of you know we here at INO are huge Norman Hallett fans. He's been a featured guest blogger here many times (see previous posts) and today I asked him to give us an exclusive preview to his new book, "Taming Risk - A trader's guide".  His post below covers Systemic Risk and the VIX. This information is extremely helpful so be sure and read on! Also for the next day or two only, he's allowing complimentary downloads of the complete book. I have read the ebook (2 days ago actually) and I can honestly say you WILL learn something that you didn't know before about risk and money management. So enjoy Norman's kindness and enjoy the special INO members only message where you can download the full book! Oh yeah comment...he wants to hear from you.

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Good Morning Trader's Blog readers!

Sentiment is emotion. In regards to how the entire investing public feels about the market can be measured in many ways and the market indices are good general objective measures of how investors and traders feel about the systematic risk in the markets.

One of the more popular measures of sentiment and systemic risk is the VIX...

In 1993, a new measurement for the index of volatility for the S&P 500 stock index  (SPX) came out. It was to become like the canary to the miner for stock option traders. If the volatility index went up, traders should start looking for the exits. You see, there is an inverse relationship between the volatility index (called the VIX) and the movement of stocks. Usually, if the stock market starts to go down, activity in stock options increases. If stocks are going up, there is less interest in stock options (hedging against losses) and the index is subdued or goes down. In other words, the correlation between the VIX and stocks is a negative one. Moreover, the sensitivity of the VIX magnifies the movement of the stock movements. For example if the S&P 500 goes down 10%, the VIX may go up 35%. Conversely, if the S&P goes up 10%, the VIX may go down 15%. But what does this mean for investors other than the VIX as a “Chicken little”(the sky is falling in) fear indicator?

VIX as portfolio insurance

Normally, when stock option traders hear the word hedge, they think of a put or spread. If an investor has a portfolio of investments and wants to protect gains, they may purchase puts to help offset any losses; the long put options become portfolio insurance. But using VIX options can be better and cheaper protection. Because of this fact, VIX options are becoming popular as portfolio insurance. Consider the following example:

Suppose you have a portfolio and you want to protect the unrealized gains against loss. Let’s say that you purchase out of the money S&P puts to protect against the down side. But as luck would have it, your portfolio grows and leaves a large gap between your out of the money puts strike price and the portfolio. Now the portfolio has more gains to lose before hitting strike price. You could close out the put position and roll up to a new strike price, but this will cost money. On the other hand, owning VIX option protection is different. There is no strike price to hit. If the S&P moves down, the VIX moves up-usually in a much larger proportion. Additionally, there is no gap to cover before going into the money. Moreover, because of the volatility of the VIX, it takes less money to “insure” against loss. It only takes about 10%  VIX option coverage to portfolio value to provide enough protection.
Lawrence McMillan, President of McMillan, a registered investment advisory firm in Morristown, NJ. provides a good example: Suppose one buys SPX Dec 1400 puts with the S&P 500 near 1530; the puts are approximately 8% out of the money. If a strong summer rally develops, the S&P 500 might rise to 1700 in September, a time when protection is most needed, as stocks tend to perform relatively poorly in the fall. But the puts are now 300 points out of the money, and therefore almost useless as protection.

VIX as a sentiment indicator

VIX can also provide a good barometer of the sentiment of the market for the next 30 days. If the VIX is going up, anxiety is going up as the VIX measures  option prices and volume increase. Importantly, VIX doesn’t have a linear relationship with the market in general; it is much more volatile. As a result, a moderate downtrend in markets will trigger a large upward movement in the VIX.

As volatility is food for the short term trader, keeping an eye on VIX can also add valuable information in helping to get a feel for the general market and looking for times of high volatility.

All in all, learning more about the VIX and VIX options may help not only in hedging situations but also in “catching bigger waves”.

Norman Hallett

Here's where you can download my new book... and it's complimentary for now.