Greed and fear are what drive investor behaviour and therefore markets - we all know that. But what we should also know is how to measure the level of greed and fear in the market at any point of time. If you can do that, and you can train yourself to adopt a contrarian stance, chances are you are well on your way to become a successful investor.

VIX - the greed vs fear monitor

One of the useful tools that gauges the level of greed and fear in the market is VIX - the volatility index. Volatility Index refers to a metric that measures the market's expectation of volatility over the short term. Volatility is defined as the "rate and magnitude of changes in prices." Volatility Index, VIX, is a measure, of the amount by which an underlying Index is expected to fluctuate, in the near term, (calculated as annualised volatility, denoted in percentage e.g. 20%) based on the order book of the underlying index options.

("VIX" is a trademark of Chicago Board Options Exchange, Incorporated ("CBOE") and Standard & Poor's has granted a license to NSE, with permission from CBOE, to use such mark in the name of the India VIX and for purposes relating to the India VIX.) (Source: NSE)

India VIX is a volatility index based on the NIFTY Index Option prices. From the best bid-ask prices of NIFTY Options contracts, a volatility figure (%) is calculated which indicates the expected market volatility over the next 30 calendar days. (Source: NSE).

Take a look at the chart above - that's the VIX for the US S&P 500 index since 1990. When the VIX is high, it indicates that traders are very fearful of heightened volatility in the near term - which means fear is high. When the VIX is low, it's the opposite - traders are very confident of low volatility in the near term - which means greed is high.

As can be seen, VIX hit a low in 2007 - when optimism (greed?) was at its highest. Be fearful when the herd is greedy is the wisdom passed on by market gurus. Wise words indeed - markets corrected hugely in 2008 and in the midst of the steep correction, fear was at its highest - which reflected in VIX peaking in 2009. Be greedy when the herd is fearful - those who followed this edict bought into panic and made a lot of money.

Today, the US VIX is at or in fact a shade lower than its 2007 lows - ie, greed is about as high as it was in 2007. What next for markets therefore?

Contrary relationship with markets

In general, VIX runs contrary to the market. When markets dip, the VIX rises. For example in 2008, markets collapsed and the Nifty sank about 500 points in just two days trading. The VIX surged 45% to 70%. The VIX shoots up when market sentiments are uncertain and falls when markets are confident about the near termoutlook. Here's a chart that shows the inverse relationship at play in India during the peak of the last bull market and the crash thereafter.

Source: BusinessToday 19th March 2009.

What's India VIX telling us now?

Here's a chart that shows us what the India VIX is telling us now:

India VIX hit an all time low in July 2017, signifying optimism levels not seen in this cycle or for that matter in previous cycles as well. There's been a small upward spike in Aug 2017 - reflecting the recent market volatility that we are witnessing now. In the battle of greed vs fear, greed is currently all pervasive. Not a good sign for a contrarian minded investor.

So the question is should you now be fearful when the herd is so clearly greedy?

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