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What you need to know about the fear gauge and how it works

From late 2016 through the end of last month, the market was cool, calm and collected, with the Standard and Poor's 500-stock index climbing more than 30 percent while a key measure of stock-market volatility - the VIX, also known as the "fear gauge" - edged ever lower.

Specialists Robert Tuccillo (center) and Matthew Greiner work at their post on the floor of the New York Stock Exchange.
Specialists Robert Tuccillo (center) and Matthew Greiner work at their post on the floor of the New York Stock Exchange.Read moreAP

Stocks go up and down. They boom, then bust, then boom.

But what if they didn't? What if the market, instead of an up-and-down slog, was a steady, ever-upward saunter? For more than a year, that's how it looked.

From late 2016 through the end of last month, the market was cool, calm and collected, with the Standard and Poor's 500-stock index climbing more than 30 percent while a key measure of stock-market volatility — the VIX, also known as the "fear gauge" — edged ever lower.

There has been an abrupt reversal in past few weeks, with big swings in the equity markets that have focused investors' attention on why volatility was so low for so long, why things finally snapped and whether baroque bets on the fear gauge may have contributed to the recent tumult.

Let's start with the basics.

What is the VIX?

The CBOE Volatility Index, better known as the VIX, is a minute-by-minute measurement of how much the stock market — more specifically the S&P 500 index — is expected to rise or fall over the coming month.

It's calculated by looking at the prices of S&P 500 options, which are contracts that give traders the right to buy or sell securities at a set price in the future. A wider variance between prices reflects more uncertainty and, thus, more expected volatility.

If the VIX is at 20, its long-term average level, it implies a belief that the S&P 500 could rise or fall about 5.8 percent over the coming 30 days.

Storm after calm

Over the past few weeks, with a tumbling-then-recovering market, the VIX has ranged from as low as 11 to just a hair over 50 — a level that implies that the S&P could be up or down by more than 14 percent in a month.

That run-up was the first time in more than two years that the VIX topped 50, and an end to what had been an eerily calm period for the stock market. For nearly 15 months, from just after the November 2016 election through Feb. 2 this year, the VIX stayed under 20 — a long, though not unprecedented, streak of below-average volatility. (The VIX also stayed below 20 from May 2004 through June 2006.)

Why were markets so calm for so long?

There are lots of opinions. But one relatively simple answer is that the economy looked OK, and stocks were rising, giving investors no obvious reason to think things were heading for a shake-up, said Jeffrey Sherman, deputy chief investment officer of DoubleLine Capital, a downtown L.A. firm that manages $118 billion in assets.

"We had a long period of low economic volatility," Sherman said. "Fundamentals were stable, there was lots of liquidity in the market, and assets were rising so people didn't feel the need to trade. Low volatility stays low volatility until it doesn't."

Now, with investors worried about inflation and rising interest rates, that low volatility is gone, at least for the time being.

Is growth in ‘passive funds’ a factor?

Another possible explanation for low volatility is the continued growth in assets invested in so-called passive funds. Those are mutual funds and exchange-traded funds that invest in the same portfolio of stocks tracked by the S&P 500 or other indexes rather than in particular stocks chosen by investment managers.

In each of the past two years, investors have pulled more than $200 billion out of actively managed funds and put that cash into passive funds, according to Morningstar. With so much money tracking the same indexes and fewer investors buying or selling based on news events or an individual company's performance, the thinking goes, it's bound to lead to lower volatility.

Sherman, though, said he thinks that has it backward. Investors have been pouring money into passive funds in large part, he said, because the stock market has been rising. That same rising market contributed to the low volatility.

"I would argue the rise in the equity market really dampened volatility more than the products themselves," he said. "Everyone's a buy-and-hold investor when the market is going up."

Betting on the VIX

You can invest in the components of the S&P 500 and other stock indexes, but you can't invest in the VIX. You can, however, invest in funds that enable investors to essentially bet on whether the VIX will rise or fall.

That might seem like plain old gambling, but there are legitimate reasons investors might want to invest in VIX-linked funds. The main one is that the VIX tends to rise when the stock market is tanking.

That's attractive to investors looking to hedge their bets. If a big asset manager has most of its money tied up in the stock market, it might also make a bet on the VIX, hoping to make a gain there if stocks tumble.

There are also ways to bet on the VIX falling instead of rising. That was a hot strategy in the past few years as volatility trended downward, but it blew up two weeks ago when the VIX spiked.

Credit Suisse said two weeks ago it would liquidate a popular fund that allowed investors to bet against the VIX. Called XIV, that fund gained significantly over the past few years, but lost more than 80 percent of its value after the VIX spiked.

Losses by investors in that and several similar funds could have made the stock market downturn worse, too. If investors used borrowed money to bet against VIX, when those positions disintegrated, they would probably face a margin call — a demand from their broker to deposit additional cash or sell other assets to cover their losses.

If investors were pushed to sell stocks to cover those busted bets, they would have been selling into an already weakened market, helping depress overall stock prices even further.

Some investors who lost their shirts might really have been betting that volatility would remain low and that the market was not headed for a correction. Others, though, may have been investing in inverse-VIX securities without knowing what they were.

Sherman said the unwinding of these trades isn't surprising, and that investors were — perhaps understandably — taken in by a market that had been remarkably calm for so long.

"There has always been a risk that these funds would go out of business overnight. That had been written about many times," he said. "But people got lulled in because this thing produced such high returns because of low levels of volatility."