Fear and Greed or Discipline and Flexibility?

|
 |  Includes: DIA, QQQ, SPY
by: Andrew Corn

In Saturday's Wall Street Journal Tennille Tracy wrote that the Volatility Index, the VIX, had closed at its lowest level of the year. That close, 20.06, remains slightly above the all-time average (19.08), and comfortably below the average of the year to date (25.22).

However, it’s nowhere near the high-water-mark set during the collapse of Long Term Capital Management. It reached an eye-popping 45.74 on October 8, 1998 — the same day that the House of Representatives voted to initiate impeachment proceedings against then President Clinton.

Some market professionals look at the VIX, “the fear/opportunity gauge,” to assess day-to-day sentiment, because the index measures how much volatility options traders expect in S&P500 stocks in the next few months. However, long-term investors know that fear alone is not a winning strategy.

Imagine, that someone used the VIX to “time the market,” with a strategy of selling when the VIX closed at or above 30 and buying when the VIX returned to 20 or below. If a person followed this strategy to “time” the S&P500, he would have done the following:

  • August 15, 2007: VIX closes at 30.67, cash out of the S&P500 at 1406.70
  • September 21, 2007: VIX closes at 19.00, buy back into the S&P500 at 1,525.75
  • November 12, 2007: VIX closes at 31.09, cash out of the S&P500 at 1439.18
  • December 21, 2007: VIX closes at 18.47, buy back into the S&P500 at 1484.46
  • January 22, 2008: VIX closes at 31.01, cash out of the S&P500 at 1310.50
  • Friday, April 24, 2008: although the VIX is still above 20, the S&P500 was 1388.82
  • This strategy would have lost 15% in 8 months! Moreover, during the time that this person was sitting on cash, he missed out on gains of 17%.

    On the contrary, imagine an investor who is agnostic toward the day-to-day emotions of other market participants. He or she would have stayed in the market during this entire stretch, and lost roughly 1% (before dividends).

    Of course, this is an oversimplification. A trading overlay on a long-term investment strategy can produce incremental alpha. Historically, it has also shown relatively how much investors will be rewarded for buying volatility on a given day.

    The detailed explanation of the VIX methodology from the Chicago Board Options Exchange can be found here: http://www.cboe.com/micro/vix/vixwhite.pdf

    (pdf file)

    The Wall Street Journal article can be found here: http://online.wsj.com/article/SB120909414580544133.html

    Disclosure: Shout Out to intern Adam Hoffman for his research and draft!