MODERN QUANTITATIVE FINANCE
RORO and Indices.
We take a look at how Indices Meters determine the Risk-On/Risk-Off Meter.
Investors are generally motivated by either greed or fear. So, given an observation of prices in the market as x(t) where t is time, the financial market is in either of the following two states:
(i) Risk-on: In the risk-on mood, investors are optimistic and greedy because they are willing to make riskier trades. The investment setting is that asset volatility and correlations between financial instruments are both low; returns (in particular of high volatility instruments) are generally high.
(ii) Risk-off: In the risk-off mood, investors are fearful and thus play it safe. The investment setting is that there is high asset volatility; correlations between financial instruments are high — which contributes to higher overall volatility; and there’s low returns (particularly for high volatile instruments).
The risk-on/risk-off (RORO) phenomenon is the root of many alpha signals in almost all asset classes. Now, to ATTEMPT to time a market and decide which state are we in, we use suitable indices.
(i) The CBOE Volatility Index (aka S&P 500 Volatility Index; or VIX Index; or simply, the VIX): This is a volatility instrument which acts as a fear gauge of US large-cap stocks, but it’s not an instrument you can trade; rather, it’s a mathematical index. This fear index measures implied volatility of the S&P 500 over the next 30 days, expressed in annualized percentage terms. This VIX’s annualized percentage is quoted in percentage points (not raw percentages) — anchored between 0 and 100 (The values mean how the market is hedging future volatility).
Get Celestine Emmanuel’s stories in your inbox
Join Medium for free to get updates from this writer.
Mathematically, the VIX calculates the expected 30-day volatility from S&P 500 option prices. This calculation is meant to represent the expected volatility of the S&P 500 over the next 30 days at a 68% confidence level i.e. 1 standard deviation of a normal probability curve.
- The VIX at 0 represents 0 percentage points of the annualized implied volatility of US equities. It means the ‘theoretical’ perfect calm markets.
- The VIX between 10 and 15 represents a low expected volatility which would signify that the markets are calm. But there is potential for sudden shocks.
- The VIX between 15 and 20 represent a healthy churn.
- The VIX above 30 signals that market players expect large swings (in either direction). It signals a ‘high risks’ period in the US equity market, but hopefully with opportunities. Now, unlike stocks which usually go up in the long term, the VIX reverts. Since the VIX would hopefully revert at extreme percentage points, when the VIX signals risk-off behaviour, a simple play is to go long beta-sensitive (risk-on) stocks (but not before the VIX starts going down). This is because when the VIX eventually subsides, markets often rebound!
- Pedantry: If the VIX rose from 10 to 35, we say it’s a +25 percentage points move. Percentage points are absolute units of measurement (i.e. standalone values).
While the VIX may represent investor expectations through representing the magnitude of expected movements in the S&P 500 index, it doesn’t tell where the index will go next. The measures of volatility (of asset/index) don’t tell the direction of the movement of the assets/index.
(ii) Crypto Fear & Greed Index: It ranges from 0 (extreme fear) to 100 (extreme greed), reflecting crypto market behavioural sentiment. A low value signals that we are in a risk-off period where investors are fearful and bearish; a high value signals a risk-on period i.e. investors are bullish (but this should warn of a potential market correction).
Sources:
Internet articles.
