Should investors worry that stock market ‘fear gauge’ is so low?

What does this chart show?
The Chicago Board Option Exchange’s Volatility Index, or Vix for short. Known as Wall Street’s “fear gauge”, it is used to measure the expected turbulence of US stocks implied by a type of derivative known as options.

Options either give buyers the right, but not the obligation, to buy an underlying security at a certain price (a call), or to sell at the pre-agreed price (a put). Vix is calculated using the prices of puts and calls that mature in roughly the next 30 days, and is designed so that a Vix level of about 20 — roughly its long-run average — means investors expect US stock fluctuations to average 1 per cent a day over that period.

However, the Vix Index has been remarkably subdued all year. This week it tumbled to below 10, its lowest closing level since December 1993, as markets responded warmly to Emmanuel Macron’s victory in the French presidential election.

Should people be worried that the fear gauge is so low?
At the start of the year, most analysts and investors expected that the presidency of Donald Trump would usher in more volatility. Instead it has evaporated, as markets have learnt to shrug off noise from Washington, and warmed to signs of a synchronised global economic recovery.

Elections in Holland and France failed to produce any further political upsets, and corporate earnings have been better than expected. Most of all, central banks in Europe and Japan still have their foot on the monetary pedal and the US Federal Reserve is moving slowly in raising interest rates.

As a result, actual volatility — not just the volatility implied by Vix — has vanished and the S&P 500 index of major US companies crested a new record high this week. However, some investors remain concerned over stretched equity valuations, geopolitical tensions and the Fed quickening its rate increases, and fret that the low Vix is a sign of complacency.

Is Vix a useful index?
Despite its moniker, Vix is an imperfect measure of fear. It follows markets rather than leads them, and does a poor job of capturing more ephemeral but very real investor worries. But it is a clean, simple gauge that responds quickly to any turbulence, which is why it is so popular.

Does it have a European equivalent?
Yes, the Euro Stoxx 50 Volatility Index, typically called Vstoxx for short. This gauge is also unusually subdued, albeit not as low as Vix, and the realised 90-day volatility of the European stock market is near its lowest level since 1990.

What are professional investors doing about it?
Some investors are clearly jittery. For example, a trader known as “50 Cent” — named as Ruffer by people familiar with the matter — has been snapping up millions of dollars worth of Vix derivatives that cost roughly 50 cents to insure against a market downturn.

But since the end of the financial crisis the winning trade has been to bet on volatility staying subdued. Indeed, if you had done so through Vix futures at the post-financial crisis nadir in March 2009, you would have been up over 4,000 per cent since. Still, this is a very risky trade, with every flicker of volatility quickly causing painful losses.

Can private investors trade the Vix?
Vix just reflects a bundle of underlying options, so you can’t invest in it directly. However, it is possible for investors to trade the Vix via a number of exchange-traded notes (ETNs are a form of ETFs) that use Vix futures contracts. However, they are very complicated instruments, with costly structures that make them unsuitable for retail investors.