Oh, The Nerve: Betting On Fear In A Volatile Market

Aug 15, 2011
Originally published on August 15, 2011 12:30 pm

If being invested in a wildly unpredictable stock market freaks you out right now, you're definitely not alone.

In fact, there's an index to measure that nervousness, and even trade on it. It's called the Volatility Index, or VIX, but it also goes by another name: the fear gauge. And during times like these, the VIX draws a lot of attention.

In 1992 in Burgundy, France, Vanderbilt professor Robert Whaley was on sabbatical. He had bought a house in the town of Aunay-en-Bazois — an idyllic setting to devise something called the fear gauge.

He brought two computers with a lot of horsepower, and he fed them a bunch of numbers dating back to 1986 in order to find a mathematical formula that could isolate and predict volatility.

"VIX gives you a notion of how uncertain the market is," he says.

Most economic data, like unemployment and GDP growth, are backward-looking. The VIX gives traders something different, because it's based on prices of contracts to buy stocks in the future.

Portfolio Insurance

Whaley compares VIX to insurance: If there's a hurricane brewing, homeowners in its path are willing to pay more for home insurance, so the price for insurance goes up. VIX works the same way.

"The market's becoming nervous that the value of their stock portfolios are going to fall, so they go rush out and buy portfolio insurance," Whaley says.

That's why a higher VIX tends to gauge market fear.

During a normal, ho-hum kind of trading day, the VIX is about 17. During the stock market crash of October 1987, the VIX — had it existed — would have hit 117.

And Aug. 8, the first trading day after the U.S. lost its top credit rating, the VIX reached 48.

There are a host of ways to bet on the VIX. In fact, it was developed for that purpose at the behest of the Chicago Board Options Exchange.

The VIX is based on the Standard & Poor's 500 index. There are similar measures based on gold and oil, as well as the Dow, the Nasdaq and other stock indices around the world.

Ben Londergan is chief executive of Group One, a firm that facilitates the buying and selling of VIX options. He spends his days in the trading pit of the Chicago options exchange, an especially chaotic place these days.

"Thirty people are screaming at one guy, 30 people are screaming at another guy," he says.

Profiting From Fear

With the stock market logging huge single-day gains and losses, the volume of VIX-related trades hit record highs this month.

"This is going to sound pathetic, but it's physically exhausting. I mean, it's mentally, extremely draining," he says.

Londergan says market crashes are good for his business, but personally, it's not fun to profit off of fear.

"As the markets are imploding and you see lots of negative things happening, you tend to have perhaps a professional victory that is very, very bittersweet," Londergan says.

Whaley, the professor who developed VIX in the first place, says he uses it to evaluate his own trades. If the VIX is high, he's less likely to act on specific company stocks.

Whaley recently bet volatility was going to go up, but he was two months too early and didn't make any money. But that's OK, he says. Hearing other people discuss the fear gauge he developed is a thrill all its own.

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RENEE MONTAGNE, host:

There's hope stocks will stabilize this week after the wild swings of last week. And for a measure of investor concern we can turn to the volatility index, or VIX - also known as the fear gauge. It essentially trades on expectations for the performance of companies listed on the S&P 500. NPR's Yuki Noguchi has more on the VIX index.

YUKI NOGUCHI: It was 1992 in Burgundy, France. Professor Robert Whaley was on sabbatical. He'd bought a house in the town of Aunay-en-Bazois. An idyllic setting to devise something called the fear gauge.

Were you drinking wine at the time and did that make you easier?

(Soundbite of laughter)

Mr. ROBERT WHALEY (Vanderbilt University Management Professor): We did enjoy the wines while we were there, but it wasn't a key element in the index design.

NOGUCHI: He brought two computers with lots of horsepower. He fed them a bunch of numbers dating back to 1986 in order to find a mathematical formula that could isolate and predict volatility.

Mr. WHALEY: VIX gives you a notion of how uncertain the market is.

NOGUCHI: Most economic data, like unemployment and GDP growth, are backward looking. The VIX gives you something different, because it's based on prices of contracts to buy stocks in the future.

Whaley, now a professor at Vanderbilt, compares VIX to insurance. If there's a hurricane brewing, homeowners in its path are willing to pay more for home insurance. The price for insurance goes up. And VIX is like insurance.

Mr. WHALEY: The market's becoming nervous that the value of their stock portfolios are going to fall. They go rush out and buy portfolio insurance.

NOGUCHI: That's why a higher VIX tends to gauge market fear.

During a normal, ho-hum kind of trading day, the VIX is about 17. During the stock market crash of October 1987, the VIX - had it existed - would've hit 117.�Last Monday, the first trading day after the U.S. lost its top credit rating, the VIX reached 48.�

There are a host of ways to bet on VIX. In fact, it was developed for that purpose at the behest of the Chicago Board Options Exchange. The VIX is based on the S&P 500 index. But there are similar measures based on gold and oil, as well as the Dow, the NASDAQ, and other stock indices around the world.�

Ben Londergan is chief executive of Group One, a firm that facilitates the buying and selling of VIX options. He spends his days in the trading pit of the Chicago options exchange, an especially chaotic place these days.

Mr. BEN LONDERGAN (Chief executive officer, Group One): Thirty people are screaming at one guy, 30 people are screaming at another guy.

NOGUCHI: And they're yelling things like this...

Mr. LONDERGAN: September 25, 32, call one by two, what's your market.

NOGUCHI: With the stock market logging huge single day gains and losses, the volume of VIX-related trades hit record highs this month.

Mr. LONDERGAN: This is going to sound pathetic, but it's physically exhausting. I mean it's mentally extremely�draining.

NOGUCHI: Londergan says market crashes are good for his business. But personally, it's not fun to profit off of fear.

Mr. LONDERGAN: As the markets are imploding and you see lots of negative things happening, you tend to have, perhaps, a professional victory that is very, very bittersweet.

NOGUCHI: The professor who developed VIX in the first place, Robert Whaley, says he uses it to evaluate his own trades. If the VIX is high, he's less likely to act on specific company stocks.

Mr. WHALEY: I remember the day that I was - October 19th, '87 I was presenting to a bunch of fund managers. These people were walking around with these blank, blank looks on their faces. That was an extremely anxious time.

NOGUCHI: Whaley recently bet volatility was going to go up, but he was two months too early and didn't make any money. But that's okay, he says. Hearing other people discuss the fear gauge he developed is a thrill all its own.

Yuki Noguchi, NPR News, Washington.

(Soundbite of music)

MONTAGNE: This is NPR News. Transcript provided by NPR, Copyright NPR.