You shouldn’t be scared of the fear index

THIS week has seen a drop in volatility in the markets from the tempestuous times of last month. Six days ago, at the height of the tensions in Libya, the Volatility Index (VIX) hit 22.13 per cent, the highest point seen in 3 months.

Despite the fact that it may seem to those concentrating on their long term investments that to ask them if they want volatility in the market is a bit like asking them if they want a punch in the face, for short term speculators, especially in CFDs and spreads, volatility is the key to profits.

The Chicago Board of Options Exchange (CBOE) which launched the VIX in 1993, tracking the S&P 500, announced that January saw a 253 per cent surge in VIX futures trading.

Hang Seng Indexes last week announced the launch of the HSI Volatility Index (VHSI) and the Hang Seng Risk Adjusted Index Series. These join the original volatility index, the VIX, as well as the VXN which tracks the Nasdaq 100 and the VXD which tracks the Dow Jones Industrial Average.

These indices have proved to be increasingly useful to market watchers and participants, their figures peppering reports of every period of market turbulence. According to Manoj Ladwa, a senior trader at ETX Capital, “you will typically see a volatility level of between 15 and 16 per cent. When it starts to break above that, then you know that there is some nervousness in the market. It wasn’t until the crash that we saw such big numbers. In 2008, we saw figures hit 90 per cent. Since then, in May last year, we saw percentages around the 45 per cent mark during the ‘flash crash’”

So how can investors take advantage of the VIX and its brethren? The VIX is quoted as an index in much the same way as the FTSE or the Dow Jones, and as Manoj Ladwa puts it “if it’s quoted, then you can offer a spread or a CFD on it”. Most mainstream CFD providers will offer spreads, such as ETX Capital, GFT, IG Index and CMC Markets.

The VIX is driven by options. As they start to see signs of downside risk in the market, banks and hedge-funds will move to mitigate risk, buying up options and driving up options. The VIX is an index of that movement. As such, Angus Campbell at Capital Spreads advises that the smart investor can use the VIX to protect themselves: “when you’re long in the market and things start to take a downturn, the VIX can be a useful instrument. Though it is not a hedge in the strictest sense, there is a negative correlation between the VIX and the market, meaning that it can be used to minimise any losses.”

It is important to point out that, not being a leading indicator, the VIX cannot be used as a predictor of the markets. Despite this, the VIX does respond extremely quickly to market movement. With this in mind, instead of bolting at the first sign of a downturn, you should keep a sharp eye on the VIX and use it to gain as others make a loss. Armed with this gauge of market movement, investors can find that volatility isn’t such a scary word after all.