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 nickname ‘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 S&P 500, 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 VIX 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 less anxious times in the financial 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.
Throughout its history, the VIX has experienced significant fluctuations, reaching an all-time high of 80.86 on November 20, 2008, during the global financial crisis. Conversely, its record low came on November 24, 2017, at 8.56, possibly influenced by the calm trading environment of Black Friday.
VIX Trading Information
MT4 Symbol: VXXB
Trading Time: Monday – Friday 08:00 – 17:00 Eastern Time
Country: United States
Currency: USD
Calculation of the VIX
Unlike stock indices, such as the S&P 500, which are calculated using the 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.
The only significant change to the formula was enacted in 2003, expanded from the S&P 100 to include the broader S&P 500. Previously, the index computation used only at-the-money options, but after it was updated, a wide range of strikes are now included.
The formula of the VIX follows the step-by-step mathematical 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, the 30-day annualised 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 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. The VIX’s sustained low levels 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.
This spike in the VIX 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 generally bullish market, where the trading 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, which can help investors pick out market tops.
Correlation
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 a bullish bias in the market. The Put-Call ratio can be used as a confirmation tool for VIX trackers. A higher VIX reading and 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). First, VXXB tracks VIX futures, not precisely the VIX itself. As an electronically traded fund (ETN), the VXXB is tradable while the VIX is not. As a result, the VXXB offers an excellent way to trade volatility. The VXXB usually moves higher when stocks decline, reflecting the sudden short-term volatility increase. 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 significant opportunities for market volatility via the VXXB, especially when forecasting the overall market direction is not certain.
Risk Management
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 dynamic position sizing technique that will help minimise their trading risks while maximising their potential rewards. As a rule of thumb, traders should trade smaller lot sizes, whereas larger lot sizes can be traded in periods of lower volatility.
Trading the VIX
The first exchange-traded VIX futures 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 stock and indices market positions.
AvaTrade enables investors to trade the VIX in a revolutionary manner away from the futures and options trading market. The index is offered as the Inverse VIX ETN (VXXB), giving traders the lucrative chance of maximising potential profitability in a risk-controlled environment.
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