VIX Shows Fearless Investors

The VIX (or the “fear index” as many like to call it) has been trending downwardly. This downward trend has occurred after the VIX was able to record an absolute maximum of $89.53 on October 24, 2008. At that time, liquidity problems, sudden bankruptcies, and downward spiraling equity market all pressured investors out of risky assets. This caused the VIX to rise dramatically, to a point at which it seemed there was no way left but down.

A quick response from both the government and the Federal Reserve helped to stabilize the US economy. It created conditions favorable for investors to return to the stock market. In fact, the S&P 500 has already been able to recover all of the losses deriving from the financial crisis. Currently, it is just a few points off from its record high. The S&P 500 rose more than 100% since the peak of the crisis, and with it the VIX index has been trending downward.

With the Federal Reserve setting its funds rate at 0.25% and injecting trillions of dollars into the economy, the yield on Treasuries was pushed so low that investors had no other option than investing in riskier assets. The stock market rose and the VIX not only dropped to the current 17.6 level, but also turned less volatile.

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Despite trending downward, there were some events that led to abrupt increases in the VIX index. In most of the cases, those events have been politically related. Discussions on the debt ceiling, fiscal cliff, and government shutdown have been igniting investors’ fears at times. Unsurprisingly, this has induced some significant increases in the VIX index. Fortunately for investors, the effect has always been temporary. Even with the downward trend, the VIX has never been compromised. In the end, politicians were able to solve their differences and the stock market recovered from earlier losses.

The above chart clearly highlights the effect that the discussions on the fiscal cliff had on the VIX at the end of 2012. Because Republicans and Democrats weren’t able to reach a compromise regarding debt cuts, the fear index increased. However, it suddenly declined due to a last minute deal being reached. It happened just in time to avoid compromising the economic recovery while it is still weak.

With another political fight approaching, the VIX started rising again in September, as the threat of a government shutdown was becoming a reality. The government has now been partially closed for more than two weeks, and the deadline to raise the debt ceiling is approaching very fast. Still, though, the fear index is not that high. With the possibility of the country defaulting on debt payments if a deal isn’t reached, it seems investors are too relaxed.

With so many last minute deals occurring over the last few years, investors believe this time wouldn’t be any different. Even though there’s still “fear,” it is perceived by investors as unlikely that a deal won’t be reached in time. The index is much more sensitive to the potential of reaching a deal than to negative developments. Proof of this is the 16% decline that the VIX experienced last Friday as investors were betting on a weekend solution reached between the parties.

At the time of writing, the index is rising again as no solution was found during the weekend. If you believe a last minute solution will be reached, then you may exploit it by buying a put on the index, or alternatively on the iPath S&P 500 VIX Future (VXX). Contracts for November have high open interest rates. This is because there are many Investors betting that the index will decline in a few weeks. If you believe it, then you may buy a November 15 put with a strike of 14, for example. At the same time, if you still fear a default, then buy a call at a high strike like 23 or 24 for the same maturity at a low price. The rationale behind this is that in one month’s time, we would be either fine with a new debt ceiling, or defaulting on debt payments.

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