Making Sense Of Market Volatility: It's All About The VIX

Last week’s market drop – and subsequent stabilization – marked the most volatile period in the equity markets since 2008. At one point on Monday, August 24 – the morning of the 1,000 point drop in the Dow Jones Industrial Average (DJIA) – the VIX indicator, the yardstick used to assess volatility in the equity markets, briefly shot up to 50 before settling back down to 40 later that day.

It is quite possible we’re entering into an extended period of volatility this fall – based in part on uncertainty about the economic health of China and the emerging markets, action (or inaction) on interest rates by our own Federal Reserve and a still richly-valued tech sector. So it’s a good time to assess your current risk appetite, review your portfolio’s asset allocation and consult with your financial advisor on any adjustments you might want to make.

Today I’d like to focus on the so-called VIX. If you were reading the financial pages over the past 10 days, many stories on the market talked about volatility and the VIX. While many investors are familiar with the concept of market volatility – markets go up, markets go down, sometimes abruptly – the VIX is not as widely understood.

The VIX is an index, or way to measure movement in the markets. It’s shorthand for the Chicago Board of Options Exchanges (CBOE) Volatility Index, and is used to gauge anticipated movement in the S&P 500 over the upcoming 30-day period. Although you can’t buy the VIX per se, it is possible to buy VIX futures, as well as options on VIX futures, much as one can for commodities like energy and agricultural production.

The investment community and the media that follow it have come to explain the VIX as the “fear gauge” for the equity markets. The higher the number of the VIX, the more fear in the marketplace about a potential crash. During times of low volatility, the VIX tends to hover between 10 and 15; a number in the mid-20s indicates mild/moderate concern, the 30s implies fear of a sharp and significant drop; the 40s represents a panic state.

I explain the VIX as being elastic, like a rubber band – it can stretch one way or the other, but always recovers to its resting state. The harder and farther it is pulled, the more sharply it will snap back, as we saw two Mondays ago.

What does the VIX mean to you and your investment portfolio? Should you track the VIX daily this fall? Should you be ready to sell everything if the VIX hits 45, for example? Absolutely not. The first rule of thumb in any market correction is to stay calm. If you’re invested in the equity markets, you should be in for the long term.

The next rule of thumb – particularly when it comes to futures and options – is to proceed with caution. A trusted financial advisor can walk you through pros and cons of these investment vehicles in respect to your specific financial goals, and help you determine whether or not it makes sense to place a bet on possible market volatility. One benefit of buying VIX options is that they help protect, or hedge, an equity portfolio on the downside– particularly in a significant correction (e.g., 20 percent or more), as options will produce a positive return to help offset losses.

This is complicated stuff. Because the VIX is trending in the financial pages right now, though, it makes sense for any investor to have a general understanding of what it represents, and to be able to have an educated conversation with a financial advisor about whether or not VIX-related financial instruments make sense to have in place during times of market turbulence.

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The global economic climate and sharp turns in the Dow and S&P have somewhat clouded our outlook for the fourth quarter. Still, there are opportunities right now for the nimble investor. Throughout this year we have been buying things selectively in certain sectors and cherry-picking stocks based on strong fundamentals –our picks are largely unchanged.  We still like the biotech sector, which can be bought into through the (IBB) ETF, and in particular, Dexcom (DXCM), Celgene (CELG), and Gilead (GILD).  We continue to favor the healthcare sector as well, whether through the (VHT) ETF, or by buying McKesson (MCK) and Boston Scientific (BSX).  We also stand by our favorite standalone picks: Under Armour (UA), Ulta Beauty (ULTA), and Lockheed Martin (LMT).  Finally, the transportation sector is offering real bargains, including the (XTN) ETF, and most of the airlines. We like Allegiant (ALGT), American (AAL), Southwest (LUV) and Alaska Air (ALK).

Now is a great time to be buying all of the great companies mentioned above because they are all on sale right now.  Next year, your portfolio will thank you for any purchases you bravely make today.

Disclosures: Warren Financial may have long positions in all the stocks, ETFs, and Mutual Funds mentioned (or implied) in this article, both for our clients and our own portfolios.  This article is not a recommendation of any particular security, seek excellent advice before investing.

For more information on how to protect your investments from volatility, visit www.WarrenFinancial.com and make sure to investigate our volatility strategies.