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!