Volatility and the VIX
Written by Rick Welch on November 7, 2016
vol’a-til’-ity n.
Volatility is a measure of the variation (the highs and lows) of a stock’s returns over a particular period of time. As a measure of risk, volatility indicates how much and how quickly the price of an investment can change. Volatility is calculated as the standard deviation of historical investment returns from its expected return. Return volatility, as measured by standard deviation, is the risk that an investment will not meet its expected return in a given period of time. The smaller an investment’s standard deviation, the less volatile or risky it is perceived to be. The larger the standard deviation, the more scattered the return outcomes, and the investment is considered more of a risk to investors. It is important to remember that standard deviation is not a relative measure which means that it is best used only when in the context of a comparison of similar or like securities or with a compatible benchmark.
Is volatility then good or bad? Depends. With higher volatility comes a diminished ability of the investor to accurately predict the expected return of an individual stock or a portfolio of risky assets. The trade-off here is that with higher volatility often comes the potential for larger share price gains. In the short term, while the wider range of investment outcomes presents a challenge to investors, in the long term those same challenges may be viewed as opportunity. While many investors view volatility as a negative, analysts and fund managers often see an increase in volatility as signaling a change in market direction before a rally. Mark Mulholland, manager of the Matthew 25 mutual fund offered the following insight. “Volatility is not a risk for long term investors like business risk (product or service obsolescence) or financial risk (excessive debt or liquidity problems), to name a few examples. When the price of a stock (or market) falls, it is normal to think that something has changed for the worse – while that will happen sometimes, it will be the exception and not the norm. Most volatility does not lead to permanent loss of capital; it is the normal result of market activity.”
An important volatility indicator is the CBOE Volatility Index or VIX which provides a relatively accurate measure of expected near-term stock market volatility. The VIX is a relative measure of the cost of buying options on the S&P 500 Index (SPX) one month in the future. Often called the “fear gauge”, the VIX derives expected volatility by averaging the prices of out-of-the-money puts and calls. Although the VIX formula includes both puts and calls, puts have a greater impact on the result. A rising VIX signals an increase in put option activity, which often means that institutional investors have become nervous about the stock market and are looking to hedge (protect or insure) their holdings from a broad market decline. Thus far in 2016, we have seen a range of VIX values between 11.02 and 32.09 compared to the long run average value of about 20. It should be no surprise that VIX was highest in mid-January (market sell-off) and then immediately after the BREXIT leave vote in late June. While the third or summer quarter is often accompanied by increased volatility, in 2016 the markets enjoyed a period of relative calm in which the VIX stayed in a range of 11 to 13 (one exception being the week of the September FOMC meeting). Since its introduction in 1993, the all-time high mark for the VIX was 80.9 in 2008 during the recent recession.
