Potential risk is always around the corner, or bubbling just beneath the surface. Ignore it at your peril.
A recent article (January 2013) by Adam Hamilton of Zeal LLC examines the role of the VIX as a leading indicator for the S&P 500. In the current bullish climate for equities and very low levels of volatility this might be a timely reminder that risk is often present when least expected.
We have reproduced the chart from the Zeal article and also added a chart of the ASX and a local volatility index. Meanwhile the full Zeal article can be found in this link.
Hamilton points out that the US market has had a strong rally with stocks at their best levels is 5 years and the S&P 500 (SPX) recording 8 new cyclical highs in 13 days. However the gains have been marked by very high levels of complacency by investors, and as contrarians would be aware, most investors become bullish only after major rallies.
The issue for investors is how best to measure the bullishness or complacency of the market. Over time a number of indicators have been developed with the best based on the option trading concept of implied volatility. Given that traders buy options to bet on future price moves investors can analyse how fast they expect markets to move in the near term. The most well known indicator here is the VIX. It is commonly known "the fear gauge" i.e., the higher the implied volatility the more fear is being reflected in the VIX and vice versa.
Hamilton's article notes that the author prefers to use VXO index as opposed to the VIX and details the rationale for this. In summary the VXO looks at near-term at the money S&P 100 options, as opposed to the VIX which amongst other differences uses the S&P 500.
Read the entire article from Sean Webster here.
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Is low volatility a sign of low risk, or investor complacency?