XIV is dead, long live VIX: A primer on Wall Street’s ‘fear gauge’

For more than a year, Wall Street's "fear gauge" -- the Cboe Volatility Index, or VIX -- was calm. Then, suddenly, it wasn't.
(Drew Angerer / Getty Images)

The stock market is volatile. Stocks go up and down. They boom, then bust, then boom.

But what if they didn’t? What if the market, instead of an up-and-down slog, was a steady, ever-upward saunter? For more than a year, that’s how things looked.

From late 2016 through the end of last month, the market was cool, calm and collected, with the S&P climbing more than 30% while a key measure of stock-market volatility — the VIX, also known as the “fear gauge” — edged ever lower.

The past few weeks, of course, have seen an abrupt reversal, with big swings in the equity markets that have focused investors’ attention on why volatility was so low for so long, why things finally snapped and whether baroque bets on the fear gauge may have contributed to the recent tumult.


Let’s start with the basics.

What is the VIX?

The Cboe Volatility Index, better known simply as the VIX, is a minute-by-minute measurement of how much the stock market — more specifically the S&P 500 index — is expected to rise or fall over the coming month.

It’s calculated by looking at the prices of S&P 500 options, which are contracts that give traders the right to buy or sell securities at a set price in the future. A wider variance between prices reflects more uncertainty and, thus, more expected volatility.

If the VIX is at 20, its long-term average level, it implies a belief that the S&P 500 could rise or fall about 5.8% over the coming 30 days.

Storm after the calm


Over the past few weeks, amid a tumbling-then-recovering market, the VIX has ranged from as low as 11 to just a hair over 50 — a level that implies the S&P could be up or down by more than 14% in a month.

That run-up marked the first time in more than two years that the VIX topped 50, and an end to what had been an eerily calm period for the stock market. For a period of nearly 15 months, from just after the November 2016 election through Feb. 2 of this year, the VIX stayed under 20 — a long, though not unprecedented streak of below-average volatility. (The VIX also stayed below 20 for a more than two-year stretch from May 2004 through June 2006.)

So, why were markets so calm for so long?

There are lots of opinions. But one relatively simple answer is that the economy looked OK, and stocks were rising, giving investors no obvious reason to think things were heading for a shakeup, said Jeffrey Sherman, deputy chief investment officer of DoubleLine Capital, a downtown L.A. firm that manages $118 billion in assets.

“We had a long period of low economic volatility,” Sherman said. “Fundamentals were stable, there was lots of liquidity in the market, and assets were rising so people didn’t feel the need to trade. Low volatility stays low volatility until it doesn’t.”

Now, with investors worried about inflation and rising interest rates, that low volatility is gone, at least for the time being.


Calm, like passive?

Another possible explanation for low volatility is the continued growth in assets invested in so-called passive funds. Those are mutual funds and exchange-traded funds that invest in the same portfolio of stocks tracked by the S&P 500 or other indexes rather than in particular stocks chosen by investment managers.

In each of the past two years, investors have pulled more than $200 billion out of actively managed funds and put that cash into passive funds instead, according to Morningstar. With so much money tracking the same indexes and fewer investors buying or selling based on news events or an individual company’s performance, the thinking goes, it’s bound to lead to lower volatility.

Sherman, though, said he thinks that has it backwards. Investors have been pouring money into passive funds in large part, he speculated, because the stock market has been on the rise. And that same rising market contributed to the low volatility.

“I would argue the rise in the equity market really dampened volatility more than the products themselves,” he said. “Everyone’s a buy-and-hold investor when the market is going up.”

Betting on the VIX


You can invest in the components of the S&P 500 and other stock indices, but you can’t invest in the VIX. You can, however, invest in various funds that allow investors to essentially bet on whether the VIX will rise or fall.

If you think that sounds like plain-old gambling, you’re not alone. But there are legitimate reasons investors might want to invest in VIX-linked funds. The main one is that the VIX tends to rise when the stock market is tanking.

That’s attractive to investors looking to hedge their bets. If a big asset manager has the bulk of its money tied up in the stock market, it might also make a bet on the VIX, hoping to make a gain there if stocks tumble.

Not VIX, but XIV

There are also — of course — ways to bet on the VIX falling instead of rising. That was a hot strategy over the past few years as volatility continued to trend downward, but it blew up last week when the VIX spiked.

Credit Suisse last week said it would liquidate a popular fund that allowed investors to bet against the VIX. Called XIV — get it? — that fund saw huge gains over the past few years, but lost more than 80% of its value after the VIX spiked last week.


Losses by investors in that and several similar funds could have made the stock market downturn worse, too. If investors used borrowed money to make bets against VIX, when those positions disintegrated, they would likely face a margin call — a demand from their broker to deposit additional cash or sell other assets to cover their losses.

If investors were pushed to sell stocks to cover those busted bets, they would have been selling into an already weakened market, helping depress overall stock prices even further.

Some investors who lost their shirts might really have been betting that volatility would remain low and that the market was not headed for a correction. Others, though, may have been investing in inverse-VIX securities without have the slightest clue what they were.

Sherman said the unwinding of these trades isn’t surprising, and that investors were — perhaps understandably — taken in by a market that had been remarkably calm for so long.

“There has always been a risk that these funds would go out of business overnight. That had been written about many times,” he said. “But people got lulled in because this thing produced such high returns because of low levels of volatility.”


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