There are several different things that traders need to keep in mind while trading the market. This includes the price action of the particular stocks they trade, general macroeconomic events, and company-specific events that might affect the company’s stock price.
In addition to these, there is an additional indicator that traders usually ignore to use. Very often, sector-wide or market-wide events impact the prices of a particular security, and traders need to be aware of these events. This will enable them to account for these events and the impacts that they might have on currently open positions.
A very effective way to keep track of entire sectors or the market at large is through indexes.
Common indexes such as the S&P 500 and the Dow Jones Index are considered barometers that measure the growth of the entire US economy.
An equally important indicator is the VIX indicator. Understanding its intricacies will allow you to become a better trader and offer you a bird’s eye view of the entire market.
In this article, VIX has been explained in detail, and several trading strategies have been discussed, which you could adapt for your own use.
NOTE: You can get your free VIX trading strategies PDF below.
What is the VIX?
The Chicago Board Options Exchange Market Volatility Index, also called the VIX, can be very simply described as a ‘fear gauge’ that allows traders to view real-time greed and fear levels in the market.
It was introduced in 1993 and has since expanded to include a futures contract and other volatility-based securities. As an index, it projects the implied volatility of the S&P 500 over the next 30 days by observing the S&P 500 options.
What are VIX Options?
Before understanding the VIX in detail, you need to understand what options are and how they influence the VIX. An option is basically a derivative that allows you to buy a share at a fixed price on a later date by paying a premium.
For example, suppose a company’s share is trading for $100 at present. You expect it to touch $110 in 2 weeks. One way to trade this share would be to buy the share right now at $100 and sell it for $110 if prices rise the way you expect them to. However, in this scenario, your $100 in capital will be tied up for the next 2 weeks, and there is still no guarantee that prices will go up. If the share price drops to $70 instead, you will end up losing $30.
This is why several traders opt to use options instead.
With an option, you would purchase a call option of the share at $100, expiring in 2 weeks. This means that you have now made a contract that allows you to buy the stock at $100 2 weeks from now, irrespective of what the market price is at the time. To enter into this contract, you have to pay a premium, say $5. Now, after 2 weeks, if the stock price goes up to $110, you will execute your call option to buy the share for $100 and sell it for $110 on the market. Thus, you will make 110-100-5 = $5 on this transaction.
However, if the share price goes down to $75, you will not execute your call option, and your loss will be just the $5 you spent on buying the call option. Therefore, your maximum downside is capped at $5 in this scenario.
There are two different types of options: calls and puts. When you buy a call, you do so with the expectation that the underlying share price will increase. A put option is bought when you’re bearish on the underlying security.
What Does the VIX Indicate?
Option premiums keep fluctuating in the market, and studying them is a useful way of getting insights into whether the market is bullish or bearish.
An increase in the premiums for call options means that people are bullish about the market, and an increase in premiums for put options indicates increasing bearish sentiment. The number of options expiring on any given day can also indicate the market’s expected volatility on that day.
The VIX index analyses the options on the S&P 500 in the market that are expiring in the next 30 days and uses this to predict the implied volatility and greed levels in the market. This is indicated as a number, and a high VIX score indicates increased volatility, which could mean a reversal of the trends.
In recent times, two of the highest VIX scores were recorded during the 2008 recession and in the March of 2020, both of which were instances when the market crashed. Therefore, the VIX also indicates fear in the market and is the basis for several trading strategies.
How to Trade the VIX
As explained earlier, the VIX is an indicator of market fear and volatility, and this means that several traders use the VIX as a major part of their trading strategies. There are two ways in which this can be done:
- To use the VIX as an indicator of where the market will move and trade different indexes and securities in the market accordingly.
- To trade derivatives of the VIX itself.
Mostly, traders opt to do the latter and trade VIX derivatives based on movements on the VIX. Numerous derivatives are based on the VIX, out of which Futures and CFDs have been discussed below.
VIX futures were introduced in 2004, and they converted VIX from an indicator into a security. They are often used as a means of diversifying portfolios and a way of hedging against risk. To understand what VIX futures are effective, it is crucial to understand how standard futures contracts work.
A future works in more or less the same way as an options contract, but with one key difference. When you bought the call option for $5, you effectively bought an “option” to buy a share of the company at the target price.
Ownership of the call option conferred upon you the right, but not the obligation, to buy the share at the given rate.
However, when you buy a futures contract, it is an obligation to buy the security at the expiry time. This is most commonly done in terms of commodities; however, stock and index futures are also commonly traded.
For example, a farmer who supplies their harvest to a conglomerate might want to sign a futures contract for their crop before planting it to ensure that even if the price for the commodity falls by the time it is a harvesting season, they will still be paid the same rate. Similarly, the buyer would be willing to sign the futures contract to protect against the possibility of prices rising in the future.
A VIX future works in the same way as a normal future, except that the VIX index is used in place of a normal security as the underlying security. Depending on the market’s idea of future volatility, the VIX futures price can be higher, lower, or equal to the current VIX price. It is this difference that traders aim to exploit to profit.
VIX CFDs also work in the same way as normal CFDs. The key underlying principle here is that VIX has a high degree of negative correlation with the stock market, which means a higher VIX would indicate greater panic and increased bearish sentiments on the market. Therefore, several traders opt to use VIX CFDs as a way of hedging risks on their investments. However, as a general rule, these CFDs don’t depend on whether the S&P 500 falls or rises; it is simply dependent on the market volatility.
People buy VIX CFDs when they expect instability in the market, which would push up market volatility and consequently the VIX prices.
For example, if you expected the Fed to make a particularly negative announcement regarding inflation rates, then you would buy the VIX expecting volatility to increase in the days following the announcement.
VIX Trading Strategies
Based on the two kinds of derivatives discussed above, various trading strategies can be formed to trade solely based on the VIX. Even if they do not directly trade the VIX, most traders keep the live VIX number in front of them at all times to account for it in all their trades. Two of the most commonly used trading strategies for trading on the VIX are;
VIX Market Timing
The VIX Market Timing is perhaps the simplest of all trading strategies. A straightforward principle governs it; a return to the normal levels follows every VIX spike as the volatility settles down.
Trading this strategy is also very simple, as the ideal entry opportunity is presented whenever there is an unusually high spike in the VIX. Most commonly, traders assume an increase to be unusual and worth trading on when the VIX crosses the upper band of the Bollinger Bands indicator using the 20-day SMA. Whenever this happens, people either short the VIX CFDs or buy put options for the future because they expect the VIX to return to its normal levels after a given period of time.
VIX Stable Markets
The second strategy is also quite similar to the market timing strategy; however, it is much more mathematical and focuses mainly on futures.
The basic underlying idea behind this strategy is that unless there is a catalyst that actively pushes market volatility up, the VIX index will almost always move down. This happens because two phenomena, contango, and leveraged ETFs, also influence volatility in the market.
Both these factors are much too complicated to be explained in this article; however, it is enough to understand that volatility rates, and therefore, VIX futures, go down over time in the absence of a catalyst. Hence, when there is relative calm in the market in periods, it is a good idea to short VIX futures, as the VIX index will soon begin to fall, resulting in a good profit.
VIX Moving Average
Since the VIX is an indicator of market fear and volatility, it itself is quite volatile.
A large portion of the market does not behave rationally, and even the shortest catalysts can spark a huge panic buying/selling wave. Therefore, while using the above strategies to trade the VIX, it would be a good idea to eliminate such useless noise and focus only on the overall trends of the VIX index.
To do this, traders often overlap the 20-day SMA of the VIX index with the live VIX price and then use this as an indicator to decide when to trade.
The 20-day SMA is simply the arithmetic mean of the VIX at market close for the past 20 days, and it reduces the noise surrounding the VIX indicators.
This can also be combined with Bollinger Bands, which add two bands to the SMA line: one above the SMA indicating a point that is 2 standard deviations above the SMA, and another 2 standard deviations below the SMA. This can serve as an ideal range where the VIX can fluctuate on any given day, and it is only a movement in the VIX beyond the bands that causes traders to open a position in it.
Lastly on Trading the VIX
In conclusion, reading the VIX can tell you a lot about the current market volatility and can also be used to indicate how people expect the market to perform in the future.
In times of fear and economic instability, trading on VIX indicators is an excellent way for traders to earn a profit. However, even this notwithstanding, every trader should be aware of the VIX as it directly affects the market at large and therefore should be accounted for in every trade.
Nishit is an accounting and finance student at the University of Warwick who has written for a range of blogs and websites including Fortune 500 companies.
He has a passion for the financial markets and has been a keen investor since he was 15.