With VIX, or Market Volatility Index, investors looking for safety bet on fear

Markets are easily spooked, and lately there have been plenty of reasons for investors to be scared. With turmoil in the Arab World, debt crises in Europe and now a natural disaster clobbering Japan, they can’t be sure quite what to expect when they wake up every morning.

Naturally, Wall Street has created a convenient and profitable solution to this: a way to invest in fear itself.

March was a record month for the popularity of products based on the CBOE Volatility Index, or VIX — also known as the “fear gauge” — which measures expected volatility in the Standard & Poor’s 500-stock index. And new metrics are emerging that will reflect Wall Street’s mood about the price of gold, oil and even individual stocks, including Google, Apple, Goldman Sachs and IBM.

Once a strategy used mainly by hedge fund managers, betting on volatility has become more mainstream as investment banks have introduced products aimed at letting investors protect themselves from losses triggered by unexpected calamities.

“You might say, ‘Oh, there’s going to be a problem in the oil market, so oil might shoot up.’ But who knows? Maybe it’ll be a financial crisis and gold’s going to shoot up,” said Bob Stock, director of capital markets research at Spruce Private Investors in Stamford, Conn. “Instead of having to pick — should I be in oil, maybe I should be in gold — VIX is sort of the universal crisis hedge.”

But it’s not that simple — and money managers agree it’s a good idea only for investors who know what they’re doing.

For one, it’s impossible to invest in the VIX directly, because it’s a synthetic metric, not an actual basket of assets. The number is based on how much traders are paying for options, a kind of insurance, to protect themselves from declines in the S&P 500. If there is broad consensus in the market that there will be higher risk or more volatility ahead, the prices of those options will rise — and so will the VIX.

For investors who want to bet on volatility, there are futures and options based on the VIX that can be traded. (Buying a VIX option, though, is essentially betting on the volatility of volatility.)

As investors become more uncertain about the markets, trading on the VIX has become a big business. The Chicago Board Options Exchange says a record 1.1 million VIX options were traded on the Tuesday after the earthquake in Japan, far more than any single day of trading even during the financial crisis.

In a move catering to more retail investors, investment banks have begun creating exchange-traded notes based on the VIX.

For instance, the VXX is tied to short-term VIX futures and counts more than $1.2 billion in assets.

The CBOE, which created the VIX in 1993, has ambitious plans for letting investors trade on the expected volatility of all kinds of assets, not just the S&P 500. In March, the CBOE filed an application with the Securities and Exchange Commission to list options that can be traded based on its five stock VIXs, which track Apple, Google, Amazon, Goldman Sachs and IBM.

Investors are flocking to VIX products, analysts say, because the fear gauge tends to move in the opposite direction of other kinds of assets. That’s attractive because the key to any successful portfolio is having a mix of assets that do not rise and fall together.

“Until a few years ago it was believed that a mix of international and domestic stocks, bonds, and cash would suffice,” Spruce’s Stock wrote in a paper in January. “However, if there was one thing that the 2008 correction taught investors, it was that it is possible for nearly every risk asset to go down at the same time.”

Except for the VIX. From June 2008 to February 2009, U.S. and international stocks fell by more than half, as did commodities.

The VIX rose 160 percent.

Since 1990, the VIX has moved in the opposite direction from the S&P 500 an average of three out of four days, according to the CBOE, leading some investors to think that a high VIX means the market has fallen too much and could be at a bottom.

But analysts cautioned against using the VIX to predict the future movement of stocks. Even when the S&P 500 continues falling, the VIX doesn’t always rise sharply, because stock declines don’t necessarily mean that investors expect the markets to become more volatile.

And because so much of the metric is driven by psychology and perception, the reactions tend to be just as fickle. So VIX products are not geared toward investors interested in buying assets and holding on to them for long.

“When you have something like what happened in Japan with the tsunami, equity markets responded very strongly, and so did the VIX,” said John Hiatt, director of research and product development for the CBOE. “But it was a very temporary response. . . . There was a large spike in the VIX, but within two or three days, it had reverted back.”

Jia Lynn Yang is a staff writer at The Washington Post who covers policy and business. Before joining the Post, she worked at Fortune magazine.
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