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‘Fear Gauge’ Helps Steer Investors

Markets are easily spooked, and lately there have been plenty of reasons for investors to be scared. With turmoil in the Arab World, debt crises in Europe and now a natural disaster clobbering Japan, they can’t be sure quite what to expect when they wake up every morning.

Naturally, Wall Street has created a convenient and profitable solution to this: a way to invest in fear itself.

March was a record month for the popularity of products based on the Market Volatility Index, or VIX — also known as the “fear gauge” — which measures expected volatility in the Standard & Poor’s 500-stock index. And new metrics are emerging that will reflect Wall Street’s mood about the price of gold, oil and even individual stocks, including Google, Apple, Goldman Sachs and IBM.

Once a strategy used mainly by hedge fund managers, betting on volatility has become more mainstream as investment banks have introduced products aimed at letting investors protect themselves from losses triggered by unexpected calamities.

“You might say, ‘Oh, there’s going to be a problem in the oil market, so oil might shoot up.’ But who knows? Maybe it’ll be a financial crisis and gold’s going to shoot up,” said Bob Stock, director of capital markets research at Spruce Private Investors in Stamford, Conn. “Instead of having to pick — should I be in oil, maybe I should be in gold — VIX is sort of the universal crisis hedge.”

But it’s not that simple — and money managers agree it’s a good idea only for investors who know what they’re doing.

For one, it’s impossible to invest in the VIX directly, because it’s a synthetic metric, not an actual basket of assets. The number is based on how much traders are paying for options, a kind of insurance, to protect themselves from declines in the S&P 500. If there is broad consensus in the market that there will be higher risk or more volatility ahead, the prices of those options will rise — and so will the VIX.

For investors who want to bet on volatility, there are futures and options based on the VIX that can be traded. (Buying a VIX option, though, is essentially betting on the volatility of volatility.)

As market uncertainty grows, trading on the VIX has become a big business. The Chicago Board Options Exchange says a record 1.1 million VIX options were traded on the Tuesday after the earthquake in Japan, far more than any single day of trading even during the financial crisis.

For retail investors, investment banks have created VIX-based exchange-traded notes.