No Fear: The Utility of the VIX
By now many people are familiar with the VIX volatility Index. It is often referred to as “The Fear Index” and talked about daily on the financial news networks. But is the VIX really of use? We think the answer is yes - particularly now that it is at extremely low levels - e.g. around 12.
One thing for sure is that the VIX can not stay at these low levels forever. Something will cause the next volatility shock. The next crisis. It's not a questions of “if” but “when”. So how can an investor capitalize on the VIX?
Understanding the VIX
The VIX earns its reputation as The Fear Gauge because of its strong anti-correlation with the S&P 500. In falling markets fear takes over and the VIX goes up. Big market losses generate bigger moves up in the VIX. A “black swan” or tail event generates a huge move up in the VIX.
Losses are amplified during these extreme events because correlations rise sharply and many asset classes fall simultaneously. The protection investors thought they had in “diversified” portfolios suddenly disappears. The Global Financial Crisis showed just that. Markets around the world crashed, volatility surged, and virtually all asset classes were dragged down with stocks.
The amplification of portfolio loss due to an increase in volatility reflects the notion of “convexity”. Convexity means something that has curvature - like an exponential curve for example. In the image below we depict how volatility can skyrocket and total asset loss in a seemingly diversified portfolio can plummet faster than the market due to increasing correlation.
The danger for clients is that it’s impossible to forecast when these events will occur. An effective tail risk strategy mitigates the impact from these extreme events, regardless of when or how often they occur, while maintaining potential for upside returns.
Convexity as an Antidote
One can capitalize on extreme moves upwards in the VIX by being long convexity - i.e. owning something that moves up like an exponential curve if the market plunges. One way to be long convexity is to be long options on the VIX. This is precisely what we do with StratiFi’s Tail Risk strategy.
StratiFi’s Tail Risk strategy specifically aims to generate crisis alpha - meaning substantial profits during a large market loss event. Windfall profits during crisis environments can provide capital for buying opportunities when stocks are cheap or for meeting required cash flows.
So the VIX is more than just The Fear Gauge. It affords an opportunity to profit from uncertainty and market volatility. Being long exposure to the VIX can mean the difference between suffering from extreme losses versus relishing windfall profits. Every advisor and every client would make that trade.
To learn more about the truth behind asset correlations and volatility, click here for our complimentary eBook "The Five Myths that Put Portfolios at Risk: Revealing the truth and improving investment outcomes using options."