What investors currently misunderstand about the VIX

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Thursday marks the one-year anniversary of the August 5 “yen shock” – a mini-panic that quickly spread across world markets after it began on Monday following the release of Japan’s July employment report.

The Nikkei stock index (^N225) lost 12 percent this Monday — the biggest drop since 1987 — while the S&P 500 (^GSPC) plunged 3 percent. The VIX volatility index (^VIX) rose to 65, the third highest level ever.

But no sooner had the morning's sell-off ended than the stunning recovery began, which may be why there isn't even a convincing, agreed-upon name for the event. By midday on that fateful Monday, the VIX in the US had already fallen to 30 – the biggest intraday crash ever.

By mid-August, U.S. stocks had already recouped their losses. But this rollercoaster ride of volatility highlights some serious misconceptions about the VIX. And historical price action around the August shocks suggests that stocks are not out of the woods yet.

The VIX has long been referred to as the “fear barometer” by the financial media (including yours truly), but that moniker oversimplifies its function. As Steve Sosnick, chief strategist at Interactive Brokers, explained in a recent episode of Stocks in Translation: “[The] The VIX is not a fear indicator. It plays a role on television.”

The VIX measures the market's expectation of the S&P 500's volatility over the next 30 days, calculated from options on the benchmark. It does not take into account actual fear, but rather reflects the market's best guess at future volatility, which often accompanies market fear or panic.

According to Sosnick, “VIX is the best indicator of demand for [institutional] Hedging protection because it really is the easiest way to hedge a portfolio quickly and in the short term.”

Institutional and retail investors alike can take advantage of deep and liquid markets for VIX futures and ETFs, as well as options on these instruments. (However, the VIX itself is an index and is not actually traded, much like the S&P 500.)

Investors might assume that a low VIX means markets are stable and hedging is not needed. But a low VIX is an affordable VIX. “Buy protection when you can, not when you must,” is the Wall Street adage. Looking back on Monday's market crash, selling the VIX by midday – either by shorting or by covering previous long positions – was the right move.

BofA's data analytics team has a historic warning for investors who have already gotten over the shock of last month.

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“August fragility leads to fall volatility (and it is not priced in),” the team wrote in a note to investors.

The team also noted that historically, the VIX tends to rise between August and October, which can negatively impact stock prices.

The chart above tracks the average VIX reading over the calendar year, using data from 1990 to 2023. The small peak in early August already perfectly mirrored the August 5 spike that rattled investors. And right now, volatility is trending up, heading higher into November.

The bank reminds investors that in previous years, markets did not immediately recover from August market shocks. There were shocks in August 2007 that preceded the global financial crisis. Then S&P downgraded US debt in August 2011 and China surprised the world in 2015 by devaluing its currency, the yuan.

Each of these years saw further downward movements for stocks.

However, the bank sees an opportunity in the current situation: “In our view, the record decline in the VIX offers an opportunity to add equity hedges at similar levels to those seen before the shock of early August and in advance of key upcoming catalysts.”

In the Yahoo Finance podcast Stocks in translationEditor for Yahoo Finance Jared Blikre cuts through the market chaos, the opaque numbers and the hyperbole to bring you important conversations and insights from across the investment landscape, giving you the critical context you need to make the right decisions for your portfolio. Find more episodes on our Video Hub or look at your preferred streaming service.

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