Measuring Fear & Greed: Understanding the VIX and AII/MI By James A. Maccaro This article was published in slightly different form on Traders.com. It is copyrighted, 2006, by Technical Analysis, Inc., and is used with the permission of the original publisher. It is an old cliché of Wall Street that investors are motivated by two factors: fear and greed. They turn bullish when convinced that profits are near, but are overcome with fear during bear markets. VIX is the ticker symbol of the Chicago Board Options Exchange’s Volatility Index, which measures the implied volatility of put and call options based on the S&P 500 stock index. The CBOE markets the VIX as an “investor fear gauge,” in that a high VIX indicates that investor’s are worried. Contrarian investors believe that the market is likely to move in a direction contrary to the consensus opinion; therefore, the VIX is a favorite indicator for many contrarians. Methods for valuing options, including the best known and most widely respected method, the Black-Scholes model created in 1973 by Fisher Black and Myron Scholes, are generally based on the price at which the option can be utilized (the strike price), the amount of time until the option expires, and volatility. The first two factors are fixed. Hence, any change in an option’s price suggests a change in perception about the stock’s volatility. A stock that has a history of wide price changes, that is, has a high historical volatility, is generally more attractive to an options trader than a stock that moves in a narrow range or, worse, flat-lines. Historical volatility quantifies a stock’s price changes over time; implied volatility is the volatility implied by a particular option price and will vary from historical volatility when investor sentiment has changed. Implied volatility will increase when investors turn bearish because options can be used as a defensive strategy to ward off loses during a bear market. A favorite tactic under this scenario is to use put options, which allow the holder to sell the underlying security at a set price, to create a floor on potential loses. The put option serves as insurance against a precipitous price drop. While there are numerous interpretations of the VIX, a level below 20 is generally considered to be bearish, indicating that investors have become overly complacent. When the VIX is greater than 30, a high level of investor fear is implied, which is bullish from a contrarian viewpoint. Is a bear market on the way? Another approach to the VIX is to focus on the speed of changes. A spike upwards of the VIX is considered to be bullish because it indicates a newly heightened perception of risk, while a sharp decline is bearish as it suggests complacent over-confidence. Volatility should not be confused with beta, which measures a stock’s price changes in relation to the overall market. Beta is sometimes referred to as “relative volatility” as it is the ratio of a particular stock’s volatility to the volatility of the overall market. A stock with a beta of one has a history of prices that moves in lock-step with the overall market. If the beta is less than one, the stock historically moves at a slower pace, while a beta greater than one reflects a history of greater changes. As beta works in both directions, that is, in both bull and bear markets, a low beta stock is likely to out-perform in a down market but will tend to under-perform during a bull market. The opposite is true of high beta stocks. Beta is a centerpiece of the Capital Asset Pricing Model, which holds that a stock portfolio should have a range of betas to eliminate “systematic risk,” that is, the risk that all of the stocks in the portfolio will tank together. Since the VIX is designed as a measure of investor fear, a natural follow-up is to look for a measure of investor greed, that is, the desire for profits. For this category, I would nominate the Affluent Investor Index (AII) and the Millionaires’ Index (MI), both developed by the Spectrum Group. The AII is based on monthly telephone surveys of approximately 250 individuals with at least $500,000 in household investable assets, approximately half of whom have a household net worth (including real estate) of at least one million dollars and are also included in the MI. The Spectrum Group estimates that affluent households (those with at least $500,000 to invest) own nearly 90 percent of stocks, bonds and other financial assets. The surveys include questions about how secure the respondents feel about their incomes, jobs and investments, as well as their plans in the coming months to invest in the stock market, mutual funds and other investments. The indexes reached lows in August and September 2004 and rebounded sharply in December 2004, after the uncertainty caused by the presidential election was removed. Likewise, the Dow fell during most of the autumn of that year but rebounded in December, more than making- up for the prior loses. In April 2005, the indexes fell sharply, which was reflected in the stock market’s performance at that time. The indexes improved in May, as did the stock market, but lost steam as the summer progressed. In the late autumn, the indexes sharply improved, which presaged the end-of-year rally. The usefulness of the MI and AII is hard to tally, particularly since the investment outlooks of affluent individuals are likely heavily influenced by the performance of their portfolios. Therefore, in the long run, the MI and AII (available at spectrem.com) could be lagging indicators, rather than predictors of changes in trends. Among the more general information revealed by the MI and AII surveys is that millionaires consistently are more optimistic than those who are only in the affluent group and that although women are generally more cautious than men when making financial decisions, their long-term investments are the same as those of men. |
Wall Street Cosmos
Research Report: Understanding the VIX and AII/MI
