Portfolio construction with understanding of investment emotion & risk/volatility

Summary: from portfolio perspective, when VIX is high, say at 30, the “rule of thumb” is keeping gross exposure at 1/3 of total deployable capital. For example, with net capital of $250K or gross maximum capital of $500k, at VIX 30, gross exposure should be kept below $160K. As VIX goes lower, say, to 15, gross exposure could rise to 60-65%. At 10 or below, gross exposure could rise to 100%. The rationale is when “fear” factor is high, the market will remain uncertain, stocks could trade in a wider range.
Also, what kind of beta stocks should be included is more a function of second derivative of VIX change. If VIX drops down rapidly, which means the market gets increasingly complacent, long high beta/short low beta should be the best strategy; vice versa. When VIX gets stablized, more plain vinilla long/short based on individual idea’s own merits should work.
VIX is “fear” factor, not the real measurement of real-time market volatility. As a matter of fact, it’s “expected stock market volatility” that’s calculated in real-time from stock index option prices and is continuously disseminated throughout each trading day.
The VIX is quoted in terms of a number between 0 and 100 — and normally trades at the far lower end of that range.  For instance, as of the close of trading on Monday, June 19 the VIX was at 17.83.

That number represents the anticipated percentage movement — both up and down — in the S&P 500 index over the next 30 days.  So, for example a VIX reading of 24 would mean that — based upon the implied volatility in the options on the S&P 500 index in the front and the second months — the index is expected to move within a range of 2% (the 24 VIX reading divided by 12 months) over the next 30 days.

Now, that doesn’t mean the S&P 500 will actually trade within that range.  Keep in mind that the VIX changes on a minute-by-minute basis, according to the ongoing changes in the implied volatility in the S&P 500’s nearest two months’ option premiums. An investor should monitor the VIX to gauge the overall level of fear or complacency in the market at any particular time, in light of the S&P 500’s recent price behavior.

Therefore, the VIX — and hence the projection of the S&P 500’s trading range for the next month — is being constantly revised.  Nevertheless, that projection — as gleaned from the latest VIX reading — is an accurate reflection of the attitude of traders and investors about current market conditions.

And that reflection of traders and investors’ attitudes is the heart of the VIX’s value.  When you can correctly gauge market participants’ attitudes — and then use that information to anticipate likely future price action — you have acquired an additional edge in your efforts to make money in stocks.

An investor should monitor the VIX to gauge the overall level of fear or complacency in the market at any particular time, in light of the S&P 500’s recent price behavior.

However, when investing, an investor should look at Beta of an individual stock, and see if his risk appetite or his market volatility judgment should justify high beta or low beta stocks to be included in the portfolio, both on the long and short side!


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