How the fear index’s cousin can make or break a stock picker

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Diversification is key to maintaining a balanced portfolio–or so the saying goes. Most investors maintain a mix of cash, stocks and bonds to minimize losses and maximize gains. Within the sub-portfolio of stocks, it can also be important to be diversified. But this

is not always possible. At times, stocks tend to adopt a herd mentality and move together. Typically, this is during periods of market decline, but not always.

The “herd index” you might not have heard of

The VIX volatility index is widely known as the “fear index,” or a gauge of what investors believe the volatility of the S&P 500 will be at a future date. It is calculated from option prices of the stocks that comprise the S&P 500. Volatility is highly correlated with market declines, so a rising VIX indicates investor sentiment is shifting negative, meaning a market decline is expected.

The VIX has a relatively unknown cousin called implied correlation, which may be considered the “herd index.” It is also calculated from option prices of stocks in the S&P 500. In addition, it includes option prices on the S&P 500 index itself. A rising implied correlation means stocks are highly correlated and moving together, while a declining implied correlation indicates stocks are moving individually, or idiosyncratically.

How to use the “herd index”

A high and rising implied correlation means that options investors are expecting most stocks to move in a herd. In that case, attempting to pick individual stocks will likely not yield additional alpha, or gains beyond that of simply investing in an index fund. One could simply buy an ETF, such as SPY, or a mutual fund that gives exposure to the S&P 500 index.

A low and declining implied correlation indicates that options investors expect some stocks to greatly outperform others. In that case, it might pay for an investor to commit at least part of the portfolio to a few individual stocks or, for the less aggressive investor, to simply commit more money to cash.

Unlike the VIX, implied correlation can rise or decline independently of the S&P 500. It’s value is to indicate when there is a shift in sentiment.

An historical example

In late summer, 2011, Congress was once again wrangling over the debt ceiling. After Standard & Poor’s downgraded U.S. debt, markets tumbled and struggled to move sideways. On September 21, 2011, the Federal Reserve announced Operation Twist, and after a brief final shakeout, U.S. stocks rebounded. The rally would last six months.

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Initially, a declining VIX confirmed investors’ fears were abating, but implied correlation continued to rise. This suggested that it was not the time to attempt to pick individual stocks, but instead be invested in broad market indices. Indeed, many stock picking hedge funds at the time were left in the rally’s dust and did not participate in the gains.

A more recent example

From March, 2015 to June, 2015, the S&P 500 struggled to make new highs. On June 29, the VIX popped up through its trendline resistance, as the S&P 500 slid back to prior support. It would maintain this support until the final breakdown on August 20.

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But, there was a warning in implied correlation in mid-July that expectations were changing. It broke down through trendline support, signaling that options investors expected stocks to become less correlated and to act individually. This could be interpreted as a signal to lighten up on index exposure.

When the S&P 500 finally capitulated in late August, both the VIX and implied correlation catapulted upwards, the former indicating fear, the latter indicating that expectations of herd behavior had returned. Eventually, as both trended downwards again, it signaled it was time to wade back into the market, with exposure favoring individual stocks as opposed to simple broad market exposure.

Today

On the final trading day of 2015, the S&P 500 is in a downward sloping trend channel, the VIX is relatively low and flat, and implied correlation also seems to be in a holding pattern. Accordingly, there is nothing compelling yet. In early 2016, it will be important to look for the first major movement and break of support or resistance in any of these three indices.

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There’s a saying that stock picking is a losing game in the long run. Warren Buffett once famously said, “Diversification is protection against ignorance. It makes little sense if you know what you are doing.”

We cannot all be Warren Buffet, but if one wishes to try, it is important to have the right toolkit. The “fear index” and the “herd index” can supplement an investor’s knowledge and perhaps provide just enough edge to beat the market.

ADDENDA:

1. Implied correlation is calculated and disseminated by the CBOE, which states on its website:

  • CBOE began disseminating daily values for the CBOE S&P 500 Implied Correlation Indexes in July 2009, with historical values back to 2007.
  • CBOE calculates and disseminates two indexes tied to two different maturities, usually one year and two years out. The index values are published every 15 seconds throughout the trading day.
  • Both are measures of the expected average correlation of price returns of S&P 500 Index components, implied through SPX option prices and prices of single-stock options on the 50 largest components of the SPX.

Ticker symbols ICJ, JCJ and KCJ are “rotated” as time elapses. For example, as of December 2015:

  • JCJ
    • Jan 2017 maturity S&P 500 implied correlation
    • Calculated using Jan 2017 equity options and Dec 2016 SPX options
    • Quotation is suspended after the Nov 2016 SPX expiration
  • KCJ
    • Jan 2018 maturity S&P 500 implied correlation
    • Calculated using Jan 2018 equity options and Dec 2017 SPX options
    • Quotation is suspended after the Nov 2017 SPX expiration
  • ICJ
    • Not quoted until after the Nov 2016 SPX expiration
    • Jan 2019 maturity S&P 500 implied correlation

See S&P 500 Implied Correlation Indexes – Historical Data

2. Some data providers include the three symbols in their streams with some variation. For instance, TradeStation uses $ICJ.X, $JCJ.X and $KCJ.X.