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Last Monday’s Greek and Portuguese credit downgrades caused a sudden meltdown in the financial markets. Out of the blue, a lot of news agencies started pointing to the abrupt spike in the VIX. Wait a minute, what the VIX?!

The Volatility Index (VIX), dubbed as the “fear index,” gauges the market’s expected volatility in upcoming 30-day period. Since volatility indicates how much an asset price could fluctuate, a higher volatility implies bigger swings in prices. More specifically, the VIX tracks the implied volatility of maturing S&P500 options. Crazy, huh?!

A rising VIX implies that asset prices are expected to have wider fluctuations, reflecting greater uncertainty or fear in the market. A falling VIX index, on the other hand, suggests the opposite.

Earlier this week, the VIX suddenly spiked up and marked its largest one-day leap since the onset of the financial crisis in 2008. Take note that, right after the VIX surged back then, equities markets all over the globe took a kamikaze dive and sold off like hotcakes! This week, US stock indices such as the DJIA and S&P500 dipped around 2%, chalking up their worst performance in months.

What gave rise to such high levels of fear in the markets?

Recently, growing concerns about debt contagion from the euro zone, the UK, and even in Asia seems to be an issue hotter than Bieber Fever! Add to that the ongoing downgrade-fest in the euro zone, which gives investors more and more reasons to be risk averse.

But wait, there’s more! The Goldman Sachs fraud investigation in the US, which could pave the way for stricter restrictions on banks, could also be one of the culprits for the market jitters. And in the UK, the upcoming elections are also causing anxiety. Is bad news just popping up from every corner or are dementors hanging out in Wall Street now?

“Uhh, Mr. Forex Gump… What has this got to do with FX trading? “

Ahh. Good question, my young padawan. I think I can illustrate this best through an example.Take a look!

PoD Chart

PoD Chart

As you can see, it’s pretty clear that whenever fear hits the markets, currency traders run to the safe-haven dollar.

Take a look at what happened earlier this week when Greece was downgraded… The index shot up by a ginormous 31%! Now that Spain has been downgraded as well, will fear take over the markets? Is this the start of a new uptrend in the VIX? More importantly, what does this all mean for forex traders?

Remember, the dollar is considered a safe haven while the yen is used primarily as a source of cheap funding. When uncertainty arises, traders begin to unwind their positions in riskier assets, taking safety in the dollar while covering their short yen positions. Given all the uncertainty and the debt issues rising all around Europe, it’s no surprise that the euro and the pound have been taking hit after hit after hit.

Meanwhile, this could benefit commodity currencies like the Aussie and Loonie. Since the Australian dollar and Canadian dollar are highly correlated to gold and oil, they could stand to benefit if traders become more risk averse. How so? Well, traders may decide that one way to diversify away portions of their portfolio would be to reduce their positions in European assets, and move them into commodities.

With that said, are traders fears warranted? Or was the recent spike a mere aberration? We shall have to wait and see! Stay tuned!