What is The
The Volatility Index (VIX) is widely considered the foremost indicator of stock market volatility and investor sentiment. It is a measure of the market’s expectation of near term volatility of the prices of S&P 500 stock index options.
Since its introduction in 1993, the index has grown to become the standard for gauging market volatility in the US stock market. This has earned it the monikers ‘fear index’ and ‘fear gauge’.
In 2003, encouraged by the ever-growing significance of the index, the issuing bodies updated the VIX to reflect its benchmark status. The VIX is now based on a wider index, the
, allowing for a far more accurate depiction of expected market volatility.
Understanding the VIX
As a volatility gauge, the VIX generally portrays investor fear or complacency. The typical indicative value is 30. When the VIXX reading is above 30, it implies high volatility and inherent fear in the market. On the other hand, when the reading is below 30, it denotes complacency, or rather, less tense times in the market.
In highly volatile times, investors usually exercise increased caution in the markets and vice versa. This innately inversely correlates the VIX with the S&P 500. When the S&P 500 goes down, the market interprets this as fear in the market, which consequently pushes the VIX higher.
Still, the VIX measures volatility, and does not necessarily indicate future market direction. Historically, the VIX posted its all-time high of 80.86 on November 20, 2008, which was during the global financial crisis. Its all-time intraday low of 8.56 was posted on November 24, 2017, and the fact that it was Black Friday probably helped impact the VIX.
VIX Trading Information
Trading Time: Monday – Friday 08:00 – 17:00 Eastern Time
Country: United States
Calculation of the VIX
Unlike stock indices, such as the S&P 500, which are calculated using prices of component stocks, the VIX is a volatility index. Its computation involves averaging the weighted prices of SPX (S&P 500) Puts and Calls over a wide range of strike prices, allowing it to estimate the near-term volatility of option prices.
As stated above, the only major change to the formula was enacted in 2003, when the index was expanded from the S&P 100 to include the wider S&P 500. Previously, the index computation used only at-the-money options, but after it was updated, a broad range of strikes are now included.
The formula of the VIX follows the mathematical step-by-step logic below when computed:
Options with expiry times of between 23-37 days are selected
The contribution to the total variance of each option is calculated
The total variance for the first and the second expiration is calculated
Next is the derivation of the 30-day variance, which is done by interpolating the two variances
The square root is computed to obtain volatility as a standard deviation
The VIX is finally derived by multiplying the standard deviation (volatility) by 100
The calculation explains that the VIX is simply Volatility times 100. As such, when the VIX reading is 20, it basically means that the 30-day annualized volatility is 20%.
Using VIX Signals for Trading
VIX Seasonal Patterns
As the primary ‘fear barometer’, the VIX index chart is particularly useful in timing market cycles
, as dictated by the fiscal year. Generally, a high VIX reading denotes heightened fear among investors, while a low reading denotes general complacency.
As stated earlier, the VIX tracks implied volatility based on the options market. The overall stock market is long-biased, which means that the VIX generally displays sideways to gradual down movements. It is the VIX’s sustained low levels that warn keen investors of potential complacency in the market.
Interestingly, market declines usually trigger an overreaction by market participants, who seek to cover their positions by buying Put options. This is what drives up the VIX, confirming over-fear among investors.
It is this spike in the VIX that can help traders time a temporary or definitive market bottom in anticipation of a longer-term higher price movement. This is especially ideal in a general bullish market, where the strategy is to pick out optimal price entry points in the direction of the overall trend. The reverse is true, with sustained lower VIX readings, which denote complacency, and this can help investors in picking out market tops.
The VIX can also be combined with other market indicators to provide an even more definitive picture of the prevailing market sentiment. The Put-Call ratio (PCR), which tracks the volume or open interest of Put options versus Call options, combines well with the VIX.
A Put-Call ratio greater than 1 implies a bearish sentiment, while a reading below 1 implies bullish bias in the market. The Put-Call ratio can be used as a confirmation tool for VIX trackers. A higher VIX reading, together with a <1 PCR figure, would be a great signal for bulls. Similarly, a lower VIX reading, together with >1 PCR figure, should signal bears are ready to take charge.
There is also an interesting relationship between the VIX and the VXXB (S&P 500 VIX Short-Term Futures ETN). To start with, VXXB tracks VIX futures, and not exactly the VIX itself. As an electronically traded fund (ETN), the VXXB is tradable while the VIX is not.
The VXXB offers an excellent way to trade volatility. The VXXB usually moves higher when stocks decline, reflecting the sudden increase in short term volatility. As well, the VXXB tends to overshoot VIX futures moves and, consequently, the overall market moves, especially during bullish periods.
With VIX serving as the primary fear gauge in the market, tracking it can help to identify great opportunities of market volatility via the VXXB, especially when forecasting the overall market direction is not certain.
Besides trading signals, VIX can also be a vital risk management tool. Prudent traders employ a variable system for optimal position sizing in the market, depending on the existing levels of volatility.
As a tool that provides information on possible levels of implied volatility, the VIX can help traders apply a
that will help minimise their trading risks, while maximising their potential rewards.
As a rule of thumb, in periods of higher volatility, traders should trade lower lot sizes; whereas in periods of lower volatility, higher lot sizes can be traded.
Trading the VIX
The first exchange-traded VIX future contract was introduced on March 24, 2004. In February 2005, VIX options were also launched and have now become one of the most traded assets on the derivatives market . Due to the typically negative correlation with the stock market, VIX options and futures have served as a natural hedge for positions in the stock and indices market.
Away from the futures and options market, AvaTrade enables investors to trade the VIX in a revolutionary manner. The index is offered as the Inverse VIX ETN (VXXB), giving traders the lucrative chance of maximizing potential profitability in a risk-controlled environment.