What is the VIX and how do you trade it?
The volatility index, or VIX, is one of the most common barometers of market sentiment. For traders, the VIX not only represents a useful tool for assessing risk, but also the opportunity to capitalise on volatility itself. Discover how you can trade the VIX – including examples of volatility trading and how to short the VIX.
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What is the VIX?
The VIX is a real-time volatility index, created by the Chicago Board Options Exchange (CBOE). It was the first benchmark to quantify market expectations of volatility. But the index is forward looking, which means that it only shows the implied volatility of the S&P 500 (SPX) for the next 30 days.
The VIX is calculated using the prices of SPX index options and is expressed as a percentage. If the VIX value increases, it is likely that the S&P 500 is falling, and if the VIX value declines, then the S&P 500 is likely to be experiencing stability.
While the VIX only measures S&P 500 volatility, it is commonly used as a benchmark for the entire US stock market. The price of options is considered a good measure of volatility as if something concerns the market, traders and investors tend to start buying options, which causes prices to rise. This is why the VIX is also known as the fear index, as it measures the level of market fear and stress.
The current volatility cannot be known ahead of time, so the VIX is best used in tandem with historical analysis of support and resistance lines.
Why trade the VIX?
VIX-linked instruments have a strong negative correlation with the stock market, which has made them a popular choice among traders and investors for diversification and hedging, as well as pure speculation.
By taking a position on the VIX, you could potentially balance out other stock positions in your portfolio and hedge your market exposure.
Let’s say that you have a long position on the stock of a US company that was a constituent of the S&P 500. Although you believe it has long-term prospects, you want to reduce your exposure to some short-term volatility. You decide to open a position to buy the VIX with the expectation that volatility is going to increase. By doing so, you might balance out these positions.
If you were wrong, and volatility didn’t increase, your losses to your VIX position could be mitigated by gains to your existing trade.
Research how the VIX works
The VIX works by tracking the underlying price of S&P 500 options – not the stock market itself. Here you’ll learn what S&P 500 options are, how the VIX is calculated and what its value means.
The VIX and S&P 500 options
The VIX measures S&P 500 options, which are options contracts that take their prices from Standard & Poor’s 500 – a capitalisation weighted index of 500 stocks in the US. They give the trader the right, but not the obligation, to trade the S&P 500 at a set price, before a set date of expiry.
A call option would give you right to buy the S&P 500 at a specific price, while a put option would give you the right to sell the S&P 500 at a specific price. The price that you choose to buy or sell the underlying market is known as the strike price.
How do you calculate the VIX?
The VIX is calculated in real time using the live prices of S&P 500 options – this includes standard CBOE SPX options, which expire on the third Friday of every month, and weekly CBOE SPX options that expire every Friday. To be considered for the VIX index, an option must have an expiry date between 23 and 37 days.
The calculation of the VIX involves extremely complex mathematics, though it isn’t necessary for every trader to understand this in order to trade the index. However, the basic theory of the calculation is that by combining the weighted prices of multiple S&P 500 put and call options over a wide range of strike prices, we can gain insight into what prices traders are willing to buy and sell the S&P 500 at. These final values will estimate the future volatility of the S&P 500.
The options that qualify for inclusion will be at the money so that they show the general market perception of which strike prices are going to be hit before expiry. This then indicates the wider market sentiment surrounding the direction of the market price.
Understanding VIX values
There is a strong negative correlation between the VIX and stock market returns. If the VIX moves up, it is likely that the S&P 500 is falling in price due to increasing investor fears. If the volatility index declines, then the S&P 500 is likely to be experiencing stability and investors are relatively stress free. Trading volatility is not the equivalent of a market downturn, as it is possible for the market to decline but volatility remain low.
Volatility is a measure of the movement of an asset’s price, rather than the price of the asset itself. This means that when you trade volatility, you aren’t focused on the direction of change, but how much the market has moved and how frequently movement occurs. This is why VIX values are quoted as percentage points.
For the past several years, if the VIX was trading below 20 then the market was considered to be in a period of stability, while levels of 30 or more indicated high volatility.
The VIX is thought to predict tops and bottoms in the SPX: as it reaches extreme highs, this is seen as a sign of impending bullish pressure on the S&P 500, and as it reaches extreme lows it is seen as bearish for the S&P 500. There is even a mantra that states: when the VIX is high, it’s time to buy. When the VIX is low, look out below.
Like all indices, when you trade the VIX, you aren’t trading an asset directly because there is no physical asset to buy or sell. Instead, you can trade the VIX by using derivative products that are designed to track the price of the volatility index.
With IG, you can use CFDs to take a position on the movement of the VIX, as well as VIX futures and exchange traded funds (ETFs). At IG, we take the exchange traded price of the VIX at any given time. Our pricing is the same as the market, so the price you see is the percentage movement in the VIX.
Decide whether to go long or short on the VIX
When you open a position on the VIX, there are two basic positions that you can take: long or short. It is important to remember that volatility traders are not interested in whether the price of the S&P 500 is going to rise or fall, as they can capitalise on both – they are instead looking at whether the market is volatile.
Going long on the VIX
The position you decide to take will depend on your expectation of volatility levels. Traders who go long on the VIX are those that believe that volatility is going to increase and so the VIX will rise. Going long on the VIX is a popular position in times of financial instability, when there is a lot of stress and uncertainty in the market.
For example, if you thought that the S&P 500 was going to experience a significant and rapid decline following a political announcement, you might take a long view of volatility. You could do this by opening a position to buy the VIX.
If there was volatility, your prediction would have been correct, and you could take a profit. However, if you had taken a long position and there was no volatility on the market, your position would have suffered a loss.
Going short on the VIX
When you take a short position on the VIX, you are essentially expecting that the S&P 500 is going to rise in value. Short-selling volatility is particularly popular when interest rates are low, there is reasonable economic growth and low volatility across financial markets.
Let’s say that the combination of low volatility and high economic growth had led to steady growth in the S&P 500 constituent’s share prices. You might decide to short volatility with the expectation that the stock market will keep rising and volatility will remain low.
If the S&P 500 does rise, then the VIX is likely to move to a lower level, and you could take a profit. However, shorting volatility is inherently risky, as there is the potential for unlimited loss if volatility spikes.
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What does the VIX measure?
The VIX measures the implied volatility of the S&P 500 (SPX), based on the price of SPX options. It is calculated and published by the Chicago Board Options Exchange (CBOE). As the S&P 500 is widely regarded as a barometer for US stock market health, the VIX is thought to measure implied volatility across US stock indices.
What does it mean when the VIX is low?
When the VIX is low, it means there is less market fear, more stability and long-term growth. The VIX typically has a negative correlation with the S&P 500, so when the VIX is low, the S&P 500 is usually experiencing a rise in price.
What does it mean when the VIX is up?
When the VIX is up, it means that there are significant and rapid price fluctuations on the S&P 500. The VIX typically has a negative correlation with the S&P 500, so in periods of market stress, the VIX increases.
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