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1 August 2014 CFA Institute Journal Review

Thirty Volatility Indexes: Worldwide Tools to Gauge Sentiment and Diversify Portfolios (Digest Summary)

  1. Neeti Goyal

Volatility and black swan events are occurrences that most investors and traders fear. The author provides an overview of Chicago Board Options Exchange volatility indices and other volatility indices with associated derivative securities. There is potential for these securities to provide a hedge for market corrections, but they should be used with caution.

What’s Inside?

The author offers a detailed discussion on the relative performance analysis and applicability of 30 different volatility indices, including the Chicago Board Options Exchange (CBOE) Volatility Index (VIX). He also discusses their use for portfolio diversification, including derivative securities based on volatility indices. Some of these VIX-related products have become very popular. But the author cautions investors to be fully informed before pursuing such trading strategies.

How Is This Research Useful to Practitioners?

Information about market volatility is useful to investors because it is a way to gauge market sentiment. It also provides investment opportunities and can be used to hedge risk. Some of the best times to buy shares are during financial panics (i.e., when the VIX is high) and to sell shares when the market is greedy (i.e., when the VIX is low). For an options trader, understanding volatility indices will make a significant difference to his or her trading strategy.

After 2008, securities that traditionally provided hedging opportunities to equities began to have a positive correlation with equities as markets became more globalized. This shift resulted in volatility indices becoming more desirable because of their high negative correlation with such market indices as the S&P 500 Index. Although the strategy may perform well when there is a significant correction and subsequent rise in volatility, holding these securities over the long term can result in financial losses for a portfolio. These losses are the result of the cost of rolling the futures to maintain a constant maturity date. During a contango market, roll-forward costs affect short-dated futures more than longer-dated futures.

How Did the Author Conduct This Research?

The author describes the CBOE VIX, which is a market volatility index that reflects the market’s expectations for volatility over the next 30 days. It is an estimate of the annualized implied volatility of the S&P 500 derived from options at a weighted 30-day horizon. The VIX is a mean-reverting, range-bound index that cannot go to zero, and following sharp spikes during market corrections, it will slowly drift back down toward its mean. The VIX signals the market.

The author presents details on the introduction of the VIX and compares the performance of other volatility indices in relation to market benchmarks both graphically and numerically since their inception and prominently from January 2008 to April 2013. He also compares volatilities for stocks, commodities, and currencies, as well as stock markets in different countries. He also mentions VIX futures, options, and benchmark indices and the impact of including these securities in a diversified portfolio in different scenarios.

Abstractor’s Viewpoint

VIX options and futures provide complex investment vehicles through which professional traders can place their hedges or implement their hunches. Irrespective of the purpose, investing in volatility is not something to jump into without a proper understanding of the markets, the investment vehicles, and the range of possible outcomes. Failing to take a prudent approach to investing can be far more dangerous to one’s financial position than just making a mathematical error in a VIX calculation.

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