We're Not Buying Fear Quite Yet

What a difference a few days can make. The VIX index, or so-called "Fear Index," was sitting near 17 on Monday of last week, a new low since the collapse of Lehman Brothers back in September 2008. Investors seemed more sanguine about the stock market's prospects than they have in months, and it looked like insurance against another big crash might finally be cheap again. But by midweek, the market was staggering from several surprises: new regulations for big U.S. banks, credit tightening in China, and increased sovereign risk through the Eurozone. The VIX surged 55% from its Monday close, and the window for buying cheap insurance on the market shut. But did the opportunity ever exist in the first place?

The Fear Index
Let's take a step back to explain what exactly the VIX index is. Briefly, the VIX index is a crude measure of the uncertainty that traders feel about the short-term prospects of the market. It looks at the prices of option contracts on the S&P 500, which will tend to be higher when uncertainty is greater, and distills the information contained in all the call option and put option prices into a single estimate of the standard deviation of returns for the S&P 500 Index over the next month. This calculation method explains why the VIX is also called a "volatility" index, in reference to the options terminology for the expected standard deviation of an asset price. For a more in-depth explanation, please see this article from our archives.

Volatility has a couple interesting attributes that make it a unique addition to any balanced portfolio. First, it is one of the only asset classes to rise whenever stocks fall (hence the VIX index's nickname of The Fear Index). Second, it can rise wildly out of proportion to the fall in stocks. Just last week the VIX rose 55% as the S&P 500 fell 4% in four days. In 2008, the VIX rose a whopping 500% from May lows around 16 to a high close of 80 on October 27, while the S&P 500 fell only 37% over the same time period. Volatility can also experience sickeningly sharp declines as the market recovers, which makes it a poor asset to always hold in the portfolio. But there is no better insurance hedge out there when the market seems too comfortable and the VIX is hovering below its long-term average of 20.

But Was the Insurance Really There?
So if the VIX fell so low just a week ago, and it provides such an excellent insurance hedge against stock price declines, why weren't we screaming and yelling for everyone to buy it? Unfortunately, the VIX index is almost entirely impossible to purchase directly. It depends on the price of a complex and constantly changing weighted portfolio of options, which we mere mortals could never replicate for a manageable cost. Instead, institutional investors and now ETF investors can purchase futures contracts that eventually settle in cash for the spot price of the VIX index at expiry. These futures contracts on the VIX index usually do a good job of following the spot index, with only minor losses each year as each futures contract expires and investors roll into the next one. Unfortunately, throughout 2009 and into this year, the prospects of a VIX futures investment looked extremely shabby thanks to a familiar foe for anyone who invested in commodity futures this past year: contango.

Because investors seeking a portfolio hedge cannot buy the VIX directly, these futures contracts bear the full brunt of panic purchases from investors seeking insurance. In 2009 and continuing into the first trading days of 2010, that kept the prices of near-month VIX futures as much as 10%-20% above the spot price, causing vicious losses as one contract expired and positions rolled in the more expensive future further out the curve. This also deadened the price appreciation that a VIX investor could expect when volatility spiked. When the VIX rose 55% last week from Monday's close to Friday,  iPath S&P 500 VIX Short-Term Futures ETN  rose only 15%. From that ETN's inception on Feb. 2, 2009, to the end of the year, the spot VIX index fell 52% while the futures-tracking ETN lost 67%. Those may sound almost equally bad, but think about it this way: You would have finished the year with half of your original investment in the spot VIX, but only a third of your original investment in the rolling futures contracts. Now think about how much harder it is to triple your investment value than to double it (not to mention how hard it is to do either one).

 

So When Is Volatility Worth Buying?
Thus far we're feeling pretty good about our decision to not buy portfolio insurance through the VIX futures ETNs. But really, we just sat on the sidelines for the past year. The real proof of our ability to use this portfolio hedge comes when we can identify the time to start buying.

First you need to know how volatility has behaved in the past. Historically, it has bounced around considerably but tends to return to a long-term average of around 20. Frequent lulls can take it down into the teens, with occasional spikes that bring the VIX up into the 30s or even 40s during shorter panics such as the 1997 Asian currency crisis, the 1998 Russian debt default, the 2001 World Trade Center attacks, and the 2008 emergency sale of Bear Stearns. Thus, it makes the most sense to buy volatility as portfolio insurance when it is under 20, or else the investment will lose money from a calm market as likely as it will gain from a new panic.

How you buy into volatility matters just as much as the price. Because buying VXX is equivalent to buying futures contracts that frequently trade in contango, holding VXX during a period of peaceful markets is going to slowly lose money even if the VIX holds steady. While panics that cause the VIX to spike do seem to happen every few years, that could be a very long wait with losses on a volatility position adding up. Instead, you should buy in slowly over time as VIX futures become cheap enough.

Checking Prices with Options
Now we can check if the prices for volatility look fair. One great resource is the options price page on Morningstar.com for  SPDRs (SPY). The largest and oldest U.S. ETF tracks the S&P 500 with incredible precision, and its options contracts are heavily traded, so it provides a good proxy for the institutional S&P 500 options used in the VIX calculations. The options page gives a calculation called Implied Volatility for each option with fresh prices, and the VIX index is essentially an aggregate of all those Implied Volatilities for all the put and call options that expire in one month.

But looking at the implied volatilities on put options over the next one to three months gives you another bit of useful information: how concerned the market is about a near-term crash. When the implied volatilities on slightly out-of-the-money put options (the ones in white rather than highlighted blue) are substantially higher than the VIX index, those options are relatively expensive and it is a sign that the market is quite concerned about a pullback. Insurance of all kinds is likely to be very expensive in this case, whether it is put options or VIX futures.

Checking Prices with Futures
The other way to assess the appeal of a volatility investment is to look at the futures prices themselves. Fortunately, the Chicago Board Options Exchange has an excellent VIX website that not only gives the recent prices for the VIX and its near-month futures contracts, but also has loads of handy historical data. You can identify the futures quotes by the appended letter and numeral (such as "VIX/G0" at the moment), which designate the month and year of their expiry.

When you buy iPath S&P 500 VIX Short-Term Futures ETN, you are buying the two futures contracts closest to expiring today. If these near-term futures look pricey relative to historical norms, as they do on January 26 at prices around 24-25, the level of the spot VIX does not matter much. But what you really need to watch for is a steep curve, where the prices of the first couple futures contracts are much higher than that of the VIX itself. When that happens, even if the futures themselves look cheap, you are likely to lose large amounts of money from the futures contracts collapsing to the spot VIX price. Buying volatility in those circumstances is like betting that a crash will come in the next couple months, impossible to predict and likely a losing proposition. Instead, look for a nice and fairly level futures curve, with prices no more than 10%-15% higher than the spot level of the VIX and no futures pricier than typical VIX levels.

Above All, Be Patient
Quite simply, there has not been a great opportunity to buy volatility as a portfolio hedge in over a year. The tumult of 2008-09 is still fresh in investors' minds and everyone else is hunting for that elusive insurance to protect their recent gains, so of course it is pricey. Good opportunities arise only when the vast majority of investors have given up.

Even when that golden chance to go long volatility happens (and believe me, we're waiting eagerly), it still pays to be patient. Remember the steady rally of 2003-07, when the VIX index sat below 20 for years on end. An all-in bet on volatility carries a huge risk of steady attrition from a bull market. Instead, a disciplined program for averaging into a volatility position over time will help keep your insurance stake at a healthy 3%-5% target size and make sure it's still there for you when the next crash finally does hit. 

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Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.