The VIX is at its lowest level in nearly 2 years...
"In the short run, the market is a voting machine but in the long run, it is a weighing machine."
So said Ben Graham, and few would argue with him about that. Fear and greed can drive share prices to crazy levels in either direction.
So it would be useful to have some figures to measure those phenomena, some statistical measures of the state of our heads. One such measure that has received greater prominence over the last couple of years is the VIX index, often referred to as the 'fear index'.
What is it?
The VIX -- or Chicago Board Options Exchange Volatility Index, to give it its full title -- is a measure of the expected volatility in the market over the coming month.
The volatility is derived from the prices at which options are trading. The price of an option depends on a list of variables, one of which is expected volatility; if we can see the prices at which options are actually trading, and we know the other variables, we can work out the implied volatility.
In finance-speak, volatility is uncertainty, and uncertainty is risk.
The VIX was created initially in 1993 as a measure of the expected volatility for the S&P 100, but was adjusted in 2003 and based on the S&P 500. For anyone who cares, the old measure still lives on and is known as the VXO, and there are similar indices on the Nasdaq (the VXN) and on the Russell 2000 (the RVX). But it's the VIX that gets talked about.
Traders can buy and sell options on the future value of the VIX, which means taking a position on the expected volatility of expected volatility. Is your head starting to hurt yet?
Can Fools use it?
Most Fools are investing in companies rather than trading derivatives. I'll pause for a moment here to allow one of our regular contributors -- you know who you are -- to add a comment at the end extolling the benefits of using derivatives. OK, moving on.
So the question for most of us is can we use the VIX to inform our buy and sell decisions. Some research by US broker Charles Schwab, which my colleague Tudor Davies has written about, seems to suggest that we can.
Others are not so sure. The Financial Times last week mentioned research showing that it had "little or no predictive or indicative value regarding the course of the market". Having said that, the same research described the VIX as "a measure of current volatility", rather than a measure of the current expectations of future volatility, so you can draw your own conclusions from that.
Where is the VIX now?
For those who consider it valuable, or are merely curious, the VIX is now at lows not seen since May 2008, indicating that we expect a calm market.
You can see graphs of the index's roller-coaster ride on this Bloomberg website.
Would I use it?
The jury is still out regarding the usefulness of the VIX, and for the meantime I am with the sceptics on this.
The VIX is interesting in that it attempts to explicitly isolate the market's expectation of volatility over the next month, and this expectation should already be implied in the prices being paid today for shares, along with many other factors. But 30 days is a short period relative to my investment horizons, so looking at this single factor over the period of a month has little relevance to me.
If I want to know how fearful people are, and not just as regards the next 30 days, I can get a feel for that from price/earnings ratios and dividend yields, for example.
I'll continue to keep an open mind on this, but the VIX is very much a voting machine tool, and I'm more interested in the weighing machine.
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