Wall Street's long dormant 'fear index' is back in play
The market's renewed volatility, after months of relative calm, means investors must brace for more big jumps and drops ahead
Europe's economy sputters, oil prices plunge and stocks start swinging wildly. Wall Street's long dormant "fear index" now predicts more turbulence ahead.
The Chicago Board Options Exchange's volatility index, known as the VIX, doubled over the past month: from 12 to 26. Although that's nowhere near the 80 reached in the financial crisis, the recent spike means traders are bracing for more big jumps and steep drops.
Slowing growth in Europe and the developing world has stirred lingering doubts among investors just as the US Federal Reserve plans to wind down a bond-buying programme that many saw as a driving force behind the market's five-year run. Traders have knocked the Standard & Poor's 500 index down 4 per cent this month and retreated into their old hiding spots, US and German government bonds.
All of a sudden, Wall Street's fear gauge looks relevant again. "We've gone from the S&P 500 hitting all-time highs to losing all its gains for the year in just a month and a half," said J. J. Kinahan, TD Ameritrade's chief strategist, referring to the benchmark index for US stocks. "There has been a sea change in how people are viewing the market."
The past week was especially turbulent. As markets plunged on Wednesday, the VIX reached levels last seen in June 2012, when worries about the European debt crisis gripped global markets and the US economy's fitful growth kept investors on edge. By Friday, as markets rallied, it slid back to 20 - its historical average.
The index gained popularity during the 2008 financial crisis. With the global economy looking shaky, the "fear index" seemed to offer a useful look at what Wall Street insiders thought would happen next. The VIX is based on prices for S&P 500 options - contracts to buy or sell the stock index at a later date - and measures how much traders expect the stock market will move in the next 30 days. When the stock market slumps, traders rush to take out insurance in the form of options contracts, pushing the VIX up.
"It's like the house is on fire, so you run to an insurance agent," Kinahan said. "The VIX shows you what people are willing to pay for insurance."