What to do as the fear gauge turns red

If you've been paying any attention at all to markets in the past couple of weeks, you'll know that volatility has been on the rise. But just how wild are the current swings can we expect things to get even more turbulent, or is a period of calm more likely? And what does increased volatility mean for your investments?

What is volatility?

When you buy a share, there are usually two big risks to worry about. One is default risk the risk that an issuer goes bust. That's why you never want to hold all of your wealth in just a few stocks. The other big risk is volatility the risk that the shares you buy fluctuate wildly in price. Clearly a big, sudden move up is good news, but in a volatile market the reverse is just as, if not more, likely.

If you can afford to ride out a rough patch and wait for prices to recover that may not be a problem. But high volatility could be catastrophic, say, the day before you plan to cash in a pension to buy an annuity. If you're playing the market via a derivative such as a spread bet, you will only be able to ride out a steep drop if you can afford your broker's margin calls (for more see here). So volatility is something you need to be aware of.

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The market's fear gauge the Vix

Capturing equity-market volatility in a single number is no mean feat. Nonetheless, that's exactly what the Chicago Board of Exchange's Vix index tries to do. To keep a long story short, the level of the index reflects the amount of implied (assumed) volatility embedded in the price of S&P 500 options.

What does that mean? There are two types of option, a put and a call. We'll take a put' to illustrate what the Vix aims to do. The put' acts as a sort of insurance policy against falling prices (a call' would do the same for rising prices). As the buyer you pay an upfront premium for the right to cash compensation should the S&P 500 fall beyond a specified level (the strike') within a set period (say, the next three months). If the S&P 500 rises over that period, the option expires worthless and you lose the premium (a bit like a car insurance policy that you never use).

One of the key ingredients in determining the option premium is the volatility of the share in question the more volatile it is, the more expensive the option will be. Now the only way of knowing for sure how volatile a share has been is to look at its behaviour in the recent past. Traders use that as the basis for a best guess as to how volatile a share will be in the future (hence the phrase implied volatility').

A complex pricing model (it was derived by a Nobel prize winner) then uses this (alongside some other ingredients, such as the option strike and expiry date) to churn out the price of the option. The Vix basically captures changes in implied volatility and hence option prices.

What is it saying now?

The Vix is currently sitting around 40. Historically that's pretty high the long-term average is nearer 20. The current reading would put it on a par with roughly where it was after the September 11th 2001 terrorist attacks, which may seem a little over the top. But the financial world has changed since the credit crunch, so that long-term average of 20 isn't a reliable benchmark. Since October 2008, the average Vix reading has been 28. That tells you something obvious volatility is now higher than usual on most days. For an all-time record the index would have to exceed 80. So where is the red alert level now? Nicholas Colas, chief market strategist at ConvergEx, reckons that these days, "unusually high" would mean a reading of "54 or so".

As a rule of thumb, the higher the Vix, the lower the S&P 500 and vice versa. An extreme high can signal that the market has bottomed out and vice versa it's reached peak fear', if you like. The other factor that goes hand in hand with higher Vix readings is higher correlations. In short, it becomes harder to get rid of risk by spreading your money over different sectors, as they all rise and fall together.

As Colas noted a couple of weeks back, "average correlations between the ten major sectors of the S&P 500 have reached 97.2%". This is the highest since the 2008 crisis. So faced with rising volatility and the added headache that traditional sector diversification may not work, what can you do?

Protection from volatility

One way to hedge market falls is to buy put' options. But we're not keen. Firstly it's too late premiums already reflect the latest volatility surge, making puts expensive. Secondly, the payoff from an option is complex. The other thing we wouldn't do is panic-sell shares in anticipation of further falls. By all means sell shares (or other assets) if you now believe that your reason for buying was invalid. But selling purely because something is falling in price along with everything else is often a recipe for regret.

Ensure your portfolio has a good range of high-quality, income-paying defensive blue chips (these tend to be less volatile than more cyclical shares). And to avoid being forced to sell at the wrong time, always hold some cash it has zero volatility and gives you the ability to jump on bargains if the Vix goes ballistic and prices drop.

This article was originally published in MoneyWeek magazine issue number 558 on 7 October 2011, and was available exclusively to magazine subscribers. To read all our subscriber-only articles right away, subscribe to MoneyWeek magazine.