What investors are getting wrong about the VIX right now

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Thursday marks the one-month anniversary of the Aug. 5 "yen shock" — a mini-market panic that quickly spread throughout global markets after beginning in Japan the Monday following the July jobs report.

The Nikkei stock index (^N225) hemorrhaged 12% that Monday — its biggest one-day drop since 1987 — while the S&P 500 (^GSPC) plummeted 3%. The VIX Volatility Index (^VIX) spiked to 65, the third-highest level on record.

But almost as soon as the selling was over that morning, the eye-popping recovery began, which could be why there's not even a compelling agreed-upon name for the event. By midday in the US on that fateful Monday, the VIX had already fallen to 30 — its biggest intraday crash on record.

By mid-August, US stocks had already erased the losses. But this roller-coaster ride of volatility highlights some critical misconceptions about the VIX. And historical price action surrounding August shocks suggests that stocks are not in the clear just yet.

The VIX has long been dubbed the “fear gauge” by financial media (including by yours truly), but this moniker oversimplifies its function. As Steve Sosnick, chief strategist at Interactive Brokers, explained on a recent episode of Stocks in Translation, “[The] VIX is not a fear gauge. It plays one on TV.”

The VIX measures the market's expectation of S&P 500 volatility over the next 30 days as calculated from options on the benchmark. It doesn’t account for actual fear but rather reflects the market's best estimate of future volatility, which often coincides with market fear or panic.

According to Sosnick, “VIX is the best proxy for the demand for [institutional] hedging protection because it is really the simplest way to do a short, quick hedge on a portfolio.”

Institutional and retail investors alike can tap deep and liquid markets for VIX futures and ETFs — along with options on those instruments. (But the VIX itself is an index and does not actually trade, much like the S&P 500.)

Investors might assume that a low VIX means markets are stable and not in need of hedging. But a low VIX is an affordable VIX. "Buy protection when you can, not when you must," goes the Wall Street adage. Thinking back to the Monday market meltdown with hindsight, the right play was to sell the VIX by midday — by either shorting or covering prior long bets.

The BofA data analytics team has a historical warning for investors who have already moved past last month's shock.

"August fragility leads fall volatility (and it's not priced in)," the team wrote in a note to investors.

The team also noted that from a historical perspective, the VIX tends to rise from August through October, which can be bearish for stocks.

VIX seasonality 1990 to 2023
VIX seasonality 1990 to 2023

The chart above tracks the average VIX level across the calendar year, using data from 1990 to 2023. The small peak around the beginning of August already perfectly captured the Aug. 5 spike that rattled investors. And right now is when volatility tends to pick up and trend higher into November.

The bank reminds investors that in prior years, markets didn't immediately recover from August market shocks. In August 2007, there were pre-global financial crisis tremors. Then S&P downgraded US debt in August 2011, and China surprised the world in 2015 by devaluing its currency, the yuan.

In each of these years, more downside for stocks followed.

In the current situation, however, the bank sees an opportunity: "In our view, the record VIX retracement offers the opportunity to add equity hedges at similar levels as before the early-August shock, and ahead of crucial upcoming catalysts."

On Yahoo Finance's podcast Stocks in Translation, Yahoo Finance editor Jared Blikre cuts through the market mayhem, noisy numbers, and hyperbole to bring you essential conversations and insights from across the investing landscape, providing you with the critical context needed to make the right decisions for your portfolio. Find more episodes on our video hub or watch on your preferred streaming service.

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