Investing

How a 'gauge of uncertainty' helps investors understand market volatility

Twenty/20

The U.S. stock market has whipsawed in recent weeks, with movements ranging from a 7.6% slump in one day to a gain of 4.9% on another. According to one closely watched gauge, investors should brace themselves for more turbulence ahead.

The CBOE Volatility Index, better known as the VIX, measures the expected 30-day expected volatility of the S&P 500. You can't trade the VIX itself; rather, it's an index that's calculated based on activity in the options market. Wall Street tracks it because of its reputation as a fear gauge.

While this index does typically spike during periods when the market is tumbling, that reflects "an enormous amount of uncertainty" in the markets, rather than fear, according to Randy Frederick, vice president of trading and derivatives for the Schwab Center for Financial Research. "I don't use the term 'fear index.' I use it as a gauge of uncertainty." 

The lower the VIX is, the calmer that pros expect the market to be over the short term, and "the longer it remains at high levels, the more you can assume that we'll have continued elevated volatility," explains Russell Rhoads, a clinical professor of finance at Loyola University Chicago and author of the book "Trading VIX Derivatives." That's because the VIX is a forward-looking measure that moves inversely with the S&P 500, he adds.

If you follow financial news, you're likely to hear about the VIX, especially when it spikes. Otherwise, this is more the arena of professionals on Wall Street. Still, here are some things you should know about this gauge, and about what it's indicating about turbulence in the month ahead.

What the VIX tells you

An option is a contract to buy or sell an asset at a prenegotiated price and by a certain date. Trading S&P 500 options is something professional investors do as a hedge or to speculate on the future direction of the U.S. stock market, Rhoads explains. That options activity is the basis for calculating the VIX.

"The most common use of S&P 500 options is to protect portfolios from losses, basically," Rhoads says. "The VIX is an indication of how much that insurance costs."

The current methodology for this volatility index has been around since 1990, and since then the VIX has ranged from levels as low as about 9 (back in 2017 and 2018) to as high as 80 in 2008. It's possible for this gauge to go above 100. 

For a long stretch of 2019 and early 2020, the stock market was unusually calm, which kept the VIX in the range of about 10 to 25 for more than a year. It began to shoot higher in late February, as traders began to worry more about the spreading coronavirus.

On March 9, this index shot above a reading of 50 — and remains above that level. That's the highest it's been since the financial crisis, when the S&P 500 was in the midst of a bear market and ultimately tumbled more than 56% before recovering and rising again.

Right now, the VIX is telling investors what they're already feeling: That the market is turbulent and likely to remain so, at least in the near term.

During periods of volatility, it's common to see big daily moves both up and down, as has happened over the past few weeks, says Frederick: "Volatility is a term that defines movement, but not direction."

The VIX and your portfolio

It's important to keep the information that the VIX is signaling in context with your own investing goals. When the VIX spikes, that suggests that some market participants are bracing for more volatility in the next 30 calendar days — which is too short of a period to focus on for most investors.

That's because these types of spikes in volatility and related market declines are to be expected a handful of times during your lifetime, and stock prices have always bounced back.

Volatility is a term that defines movement, but not direction.
Randy Frederick
Vice president of trading and derivatives for the Schwab Center for Financial Research

Using a strategy known as dollar-cost averaging, in which you regularly add money to the market at set intervals, you could take advantage of periods of market turbulence to buy stocks at lower prices.

"If you're a long-term investor, you definitely shouldn't try to bail out of the market right now," Rhoads said. 

Finally, stay focused on your goals, and don't get distracted by information that's not relevant to you, Frederick advises. While the recent turbulence in the market has been unsettling, it's not unprecedented — and it could stick around for a stretch until market participants have a clearer picture of how the coronavirus or slump in oil will effect global economies.

"We're trying to prepare people for the fact that this volatility could last a while," Frederick says. "Maybe it's best if you just don't pay attention to it."

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