Gold and the Vix: why the two fear indices matter

FOR the last four years, pictures of traders with their hands on their faces have been a staple of financial newspaper picture desks. And that doesn’t seem to be anywhere near to ending. Markets are jumpy, with the doomed €100bn gamble to bail out Spain’s banks. But volatility and market uncertainty needn’t be traders’ enemy – there are plenty of ways to take a position on both volatility and on market uncertainty.

Known by many as the fear index, the Chicago Board of Trade volatility index (Vix) is used as a measure of the S&P 500’s volatility. Launched by the Chicago Board Options Exchange, there are other measures, such as the HSI Volatility Index (VHSI) and the Hang Seng Risk Adjusted Index Series, the VXN which tracks the Nasdaq 100 and the VXD which tracks the Dow Jones Industrial Average. But the Vix is the most commonly quoted.

Though it is not a leading indicator, the index is useful in measuring the perceived fear in the markets. The Vix is driven by options trading and is calculated as a positive percentage, reflecting the expected volatility of the S&P 500 over the next 30 days. As banks and hedge funds start to see signs of downside risk in the markets, they will move to mitigate risk by buying up options. The higher the expected swings in price, the higher the premiums charged by writers of options.

The Vix will typically trend in the 15-16 point area, but nervousness in the market can see it jump above that. The Vix came close to spending the duration of yesterday’s London session above 21.

Gold is often seen as the strongest haven asset – a store of value since before biblical times. And it is this faith in its ability to maintain its purchasing power – as central banks erode the value of their fiat currencies and investor mistrust wipes billions from stock markets – that has helped to drive gold’s 10 year bull run. In a risk-off environment, we will often see gold surge as investors flee to safety.

As such, you might expect to see a strong correlation between gold and the Vix. But as you can see from the chart below, they seldom trend in line. The current structure of the Vix has existed for 21 years, but over this time gold and the Vix have had a correlation of less than 5 per cent with a standard deviation of 27. But just because gold and the Vix do not always show a strong correlation, that does not mean that they are not useful to use together – besides being handy as a way to take a position on market uncertainty in their own right. According to research from ConvergEx Group’s Nicholas Colas, at times the relationship between the two can reach as high as 76 per cent – as happened when the bursting of the teach stocks sent the markets spiraling in October 2002. According to Colas,“the real ‘buy’ signal for stocks is when the gold-Vix relationship begins to decline from its peak.”

Traders can use the Vix as a hedge against volatility in the S&P and in the equities market as a whole. And, with neither gold nor volatility set to plummet just yet, traders should keep an eye on the correlation of the two for an indicator of ongoing market sentiment and for signs that the market is reaching the bottom.

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