You would have heard of VIX (Volatility index) before. It is a term often used to gauge volatility in the financial markets. But what is VIX (Volatility Index)? VIX provides a benchmark for the pricing of options. Options are like insurance products in financial markets. The insurance premiums shoot up when insurance provider becomes extremely uncertain about future or have high risk perceptions. In the same way, in uncertain and fearful times, the option writers (insurance provider) jack up the premium prices on insurance products when they are extremely fearful and uncertain about future. This gets reflected in VIX. The VIX is derived from a real-time calculation that averages the weighted prices of out-of-the-money puts and calls on the index. The resulting measure provides a benchmark for anticipated volatility in the index as a whole over the next 30 calendar days. VIX is also called Fear index. VIX is not a reflection only on equity markets but tells us the state of complete financial market landscape.
Why Leverage of 30 times was completely acceptable in 2004-2007? Large Financial Institutions across the world are collapsing and everyone is blaming that management of these companies took too much risk, much more than they could have handled. Is that so? Fact: The management of these companies knew that they were taking excessive risk but they also knew that they can handle it. Remember, in markets risk perse is not bad...what matters is risk management. Most of the companies assumed that their risk management practices were sound. This was not just the management's belief but also the belief of analyst community. That's why no one raised any red flag on business model of investment banking business till things started falling apart. Where management of the companies went wrong - is in their assumption: World will be like this forever. Stability leads to Complacency. "Perception is Reality". 2004-2007 was an era of low volatility. (Low VIX). Low Volatility = Low Risk = More Leverage. It was much easier to manage risk in a stable market environment. And that's why everyone was ok with the excessive leverage. What changed in 2008? - were not the leverage levels but the Volatility. The sudden spike in Volatility changed the risk perception and suddenly the entire business model started collapsing. It became just too difficult to manage risk and price assets in an unstable market environment. The "mark to market" accounting became too difficult to manage and companies suddenly found themselves going under water in no time.
2008-2011: Welcome to Period of High Volatility. Now times have changed and with it the thinking. Leverage now is a bad word because it is just impossible to manage now-a-days, and hence people are getting rid of it. The level of 40 on VIX is now considered as level of low volatility, which in 2004-2007 - was an extreme level. The stable market environment of 2004-2007 created a sense of complacency in financial market system and every financial engineering innovation that happened during that period is now collapsing. This will no doubt create excessive pain for everyone. Periods of High Volatility signifies risk perception and uncertainty market participants have about future. As long as VIX remains at elevated levels, the market will remain a traders market; and gains will be difficult to stick. As per psychological studies, human beings become extremely short term in their thinking in stressed conditions. Hence, in periods of high VIX, gains will be smaller and short lived. The normal old fashioned market will not return till we see a substantial cool down in VIX. Hence, keep an eye on VIX to formulate your strategy. May be Instability is the new world order, and we need to learn to live in times like these.