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What is the VIX?
The “VIX” is the CBOE Volatility index that measures the market’s expectation of volatility over the coming 30 days in the S&P 500 index — the benchmark stock market in the US, based on index options. Originally published in 1993, it is produced by the Chicago Board Options Exchange (CBOE).
In simple terms, volatility is the statistical tendency of a market to go up or down sharply within a certain period of time. It is measured by standard deviations – that is, how much a price deviates from what is expected, which is generally its mean.
The VIX is often known as Wall Street’s “fear gauge” as investors use it to identify investor sentiment and the overall health of the entire US equity market.
In essence, if the VIX stays below 20, then market participants’ worries would be considered moderate. However, if it goes above that, people could sense there are bigger things on the horizon to fear.
How does the VIX work?
The VIX index is the most closely watched gauge of implied volatility of stock markets. It is worth digging into what that means.
- Implied volatility represents the current market pricing based on its expectation for movement over a certain period of time. This forward-looking figure allows a trader to calculate how volatile the market will be going forward.
- The VIX can help investors estimate the implied move and range for the S&P 500 index with a significant degree of confidence in the next 30 days. This can be extremely useful for calculating stop distances and position size.
To understand the mechanics, the VIX reflects the cost of buying short-term options on the S&P 500, which pay off if stocks move significantly over the next 30 days. That means the VIX does not track the underlying price of the stock market itself.
The index uses live prices of S&P 500 options.
- Options are derivatives that give the holder the right to buy or sell the S&P 500 at a specific price, which is known as the strike price.
- This includes standard CBOE S&P 500 options, which expire on the third Friday of every month, plus weekly S&P 500 options that expire every Friday.
- The option must have an expiry date between 23 and 37 days to be considered for the VIX index.
The combination of the weighted prices of multiple S&P 500 options over a wide range of prices allows traders to understand where the market is willing to buy and sell the S&P 500 index. These values will then estimate the future volatility of this benchmark stock market.
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The values behind the VIX
Calculated by prices in options, a higher VIX reading signals higher stock market volatility, while low readings mark periods of smaller volatility.
This implies the VIX has a strong negative correlation with the performance of the stock market.
- When the VIX rises, it is possible that the S&P 500 will fall due to increased uncertainty.
- Conversely, if the VIX falls, the S&P 500 is more stable and there are less fears in markets.
Remember that volatility can remain low, while it is still possible for the market to drop in value. Volatility measures the change in movement in price; it is not a measure of the price of the S&P 500 itself. The direction of change is not important, but rather how much the market has moved.
Here’s how you can read the VIX:
- Generally, a reading below 20 indicates market stability, whereas
- A level above 30 is deemed to be elevated and signals heightened volatility
For the record, the all-time intraday high was 89.5 which occurred in 2008.
Comparing the actual VIX levels to those that might be expected is helpful in identifying whether the VIX is “high” or “low” and can provide clearer indications of what the market is predicting about future realised volatility.
Why trade the VIX?
Due to its strong relationship with stock markets, the VIX is typically used to hedge against a falling stock market or to make a bet on extreme moves in prices. Holding a VIX position might also offer diversification with stock positions in a portfolio.
The ‘fear index’ allows investors to generate potential returns from the expected volatility levels of the S&P 500 index. Of course, fear has its origins in investor psychology, as fear in the market always causes very sharp price action, which occurs during panics.
The greater the extent of the panic, the more sharply the VIX rises, as investors anticipate price declines from stock markets. Trading on the VIX also allows you to make potential returns when the trend reverses and positive sentiment returns to the market.
This is why VIX trading has become particularly popular with traders trying to find the highs and lows of euphoria and panic and with traders playing strategies based on forecasts of events that could affect the economy.
How to trade the VIX?
When you trade the VIX, similar to other indices, you aren’t trading an asset directly because there is no physical asset to buy or sell. Instead, you trade the VIX by using derivative products that are designed to track the price of the volatility index.
It is also important to remember that trading volatility implies you’re not exclusively concerned with whether the stock market or S&P 500 prices rise or fall.
There are two positions you can take. These depend on your expectations of the level of volatility and not the direction of the rise or fall in the price of the S&P 500:
- A long position – you think fear and uncertainty will rise and push the S&P 500 lower, perhaps due to an economic or political announcement.
- A short position – if you short the VIX, you assume that the S&P 500 will rise.
Diminished volatility is typically observed during periods of market stability and minimal uncertainty, coupled with consistent economic expansion, which often results in upward movement of stocks and a decrease in the VIX.
Contrarian traders could also potentially benefit from adopting a short position during time of extreme fear, as they anticipate a subsequent improvement in market sentiment over time.
Conclusion
Fear and greed are the two key ingredients that feed volatility. They are the real foundations of price action when volatility increases and can occur on any time frame.
Watching the VIX gives us an idea of what markets think may happen to global markets in around one month’s time. Trading the VIX via CFDs enables us to navigate this volatility and potentially seize opportunities on the abrupt price action that may ensue.
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