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Battle of the Fear Indexes

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At the moment, risk may seriously outstrip reward.

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A couple of months ago, Credit Suisse (CS) rolled out a new and improved "fear index."

The de facto standard for such indicators is the VIX, with which nearly everyone is familiar. The higher it goes, the more fear there ostensibly is in the marketplace.

But the VIX is subject to movements not necessarily related to sentiment, and it can even move counter to how it "should." For example, if a big trader needed a slug of call options to bet on a market rally, then it's possible that could make the VIX rise.

As observers, when we see the VIX rise, we assume there's more fear in the market -- but in this care, the underlying cause for the jump was a bullish bet. Confusing, no?

So CSFB created a new index that compares the premiums in calls versus puts, digging a layer deeper than the VIX does. When the indicator was first unveiled, its movements didn't make a lot of sense when compared to the VIX. But a recent article on Bloomberg highlighted one potential use for it: Identifying times when the VIX is masking underlying sentiment.

We're seeing that now:

There have been 4 other times during a bear market when we've seen a divergence like this, with the VIX at a multi-month low and the CSFB Fear Index at a multi-month high. Over the next 3 months following those 4 instances, the S&P averaged a 9.2% decline, with a risk that averaged more than 6 times greater than the average reward.

No positions in stocks mentioned.

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