Decomposing the VIX index into greed and fear
Greed and fear are the main psychological factors driving investment decisions, and the VIX Index is regarded as the most important measure of how fearful the market feels about future returns of the main equity index, the S&P 500 Index. However, given that the VIX is calculated by combining both upside expected volatility implicit in out-of-the-money calls and downside expected volatility implicit in the value of out-of-the-money puts, the taken-for-granted assumption that a rising VIX should be interpreted as a sign of growing fear in the equities market can be misleading. In this paper we formally deconstruct the index into two components, the upside and the downside expected volatility, in a similar fashion as it is done in statistics with the semi-variance. We then propose a Greed-Fear index using the data obtained to provide a better gauge about investors' sentiment on the market.