What is the VIX?
This is the Chicago Board Options Exchange’s ticker symbol for the volatility index. The VIX indicates the implied volatility, i.e. the short-term intensity of the price fluctuations of the index options of the S&P 500.
Take a look at the two pictures below. The increasing volume of the VIX’s futures options indicates increasing interest.
VIX futures volume
VIX options volume
Why is the VIX called the Fear Index?
The VIX reflects the market’s short-term expectations regarding the volatility of the stock market. When the VIX rises, traders expect the market to become volatile.
As volatility increases, so too does uncertainty and uncertainty. Uncertainty means risk. The higher the risk, the higher the fear level. This is why many traders refer to the VIX as a fear barometer.
What are the main features of the VIX?
VIX daily chart
An interesting feature is that the VIX has a very positive tendency: it rises more and at a faster pace than it falls.
There is a reason for this positive trend because the VIX is synonymous with fear. Fear spreads quickly and leads to panic. In any case, it is not often that fear subsides quickly.
Another important feature is the return to the mean. For example, company stocks can exhibit long-term trends due to changes in fundamentals (i.e., not reverting to the mean). The VIX, on the other hand, is a measure of volatility and not a measure of value.
How do you trade the VIX?
It’s an index, just a key figure. You can’t buy and sell a metric. What you can do is buy and sell its derivatives.
ETF (Exchange-Traded Funds) and ETN (Exchange-Traded Notes)
ETFs: index funds traded on the stock exchange
ETNs: publicly traded debt securities
You can use ETFs and ETNs to speculate on one direction each. However, they are imperfect replicas or reference indices of their performance.
The most successful example is the short-term futures ETN of the iPath S&P 500 (VXX). VIX futures of the first and second month are used, with a daily roll-over.
Similar exchange-traded products are again differentiated according to duration and leverage. (For example VXZ, VIIX, TVIX, UVXY, VIXY)
There are also products that produce reverse performance. (e.g. XXV, XIV)
Futures and options
VIX futures are based exclusively on implied volatility (fluctuation intensity). In fact, all of the above ETNs and ETFs use VIX futures to create the tracking portfolios you want.
Their options allow you to speculate on the index using puts and calls. However, these volatility-based options are complicated. This is because their price is based on the volatility of the volatility.
Trading strategies for the VIX
Hedging against the stock market
The most common reason to trade the VIX is to hedge against a stock market crash. Since there is usually an opposing correlation between the volatility index VIX and the stock market, the VIX offers a good hedging option. This correlation ratio means that when the volatility of the VIX increases, the S&P 500 usually falls, and when the volatility of the VIX decreases, the prices of the stock market rise.
Related Posts: To hedge your stock positions, buy out of the money VIX call options.
If the stock market crashes, the options will ideally increase in value. The profit will then offset the losses in the stock market. If the price does not fall, the options will expire worthlessly. Because out-of-the-money options are inexpensive, this strategy enables cheap hedging.
However, since options cannot offer perfect protection either, losses are still possible. But if the price fluctuation in the index turns out to be drastic, it is possible to close with a profit despite the hedge. Of course, the result depends on your insurance relationship. The Options Guide contains a detailed article about hedging with VIX options.
Protection with the VIX
“Be greedy when others are afraid.”
How do you know when others are anxious? Use the fear index.
If the VIX soars to an extreme high, there is a possibility of bottoming out. Of course, there is no guarantee of this, but high market values in the VIX deserve attention.
VIX and SPY
VIX – Extremely high VIX values | SPY – market lows
More trading ideas for the fear index
Blog with interesting analyzes of the VIX
Use and understand the volatility index
VIX – a useful mood indicator
In extreme price movements, it is emotions, not fundamentals, that drive the market. Therefore, it makes sense to quantify emotions and moods.
The VIX is one of a number of sentiment indicators. Other indicators of this type are Put-Call-Ratio (the ratio between puts and calls) and the NYSE Bullish Percent Index (the NYSE’s bullish percentage index).
If you want to learn more about it, I recommend the following books:
Trading VIX Derivates: Trading and Hedging Strategies Using VIX Futures, Options, and Exchange Trades Notes by Russell Rhoads
Trading Volatility for Profit: Using VIX as a Predictive Indicator to Find Winning Trades by Lawrence G. McMillan
“Trading Connors VIX Reversals” by Gregory Che
This article was originally published by Galen Woods on his website: A Guide to Trading the CBOE Volatility Index (VIX) – The Fear Index