Predicting Volatility with The VIX
The VIX is an index, a technical indicator and a security you can trade all in one. It is arguably the best gauge of risk and sentiment available to the investing public and can be used effectively by any trader within any market. This series of articles will define what the VIX is and how it works. You will learn how to use it within your daily analysis and how to invest or trade the VIX as a potential source of profits.
[VIDEO] Predicting Volatility with the VIX – Part 1
The VIX is often nicknamed the “fear index” which is actually somewhat misleading since it doesn’t directly measure fear of any kind. The VIX is actually a measure of trader’s expectations about volatility in the S&P 500. The VIX is charted like an index and the higher it goes the higher trader’s expectations are for short term market volatility.
The VIX rises with higher market volatility because it measures the prices of the out of the money S&P 500 index options. If option sellers think volatility is going to increase (in the near term) they will require larger premiums from option buyers. This increase in option prices is used in the calculation for the VIX index. Conversely, if traders think volatility is going to drop option sellers will have to reduce premiums to attract buyers. Falling option prices will be reflected in a falling VIX index.
The VIX will track these changes in investor sentiment and option premiums in real time each trading day. The VIX is reading 30 or 30% as this article is being written which is an annualized number of how much traders think the S&P 500 will move over the next 30 days. That means that traders think the S&P 500 is likely to move about 2.5% (30% / 12 months = 2.5%) over the next month.
Trader expectations as shown on the VIX are directionless. In the example above we can understand that traders are expecting a 2.5% move one direction or the other but not specifically up or down. However, because unexpected market volatility is biased to the downside a rising VIX is usually associated with bearish expectations. Remember that the market doesn’t crash up it only crashes down.
That means that if traders are expecting a lot of volatility it is generally a bearish sign. That is one of the reasons the VIX is often called a measure of fear. If investors are concerned that volatility is increasing the VIX will rise. Conversely, if investors are expecting low volatility the VIX will drop and that is considered bullish. This rule is generally true but you will see exceptions on a day-to-day basis. We will talk about that more in the next article in this series.
The implications here are obvious. If the VIX is falling, investors are trading bullish strategies and taking on more risk. If the VIX is rising, traders may be shorting the market and trying to limit risk within their portfolio. Because the VIX is typically range bound traders are particularly interested in periods when the index is hitting support or resistance levels.
How bearish or bullish traders feel based on the VIX index is important because it indicates what is going on with attitudes towards risk. Recently, increases in investor fear have been associated with falling stocks, rising bonds and a stronger dollar. The same is true in reverse as the VIX has been retreating from multi-year highs in early 2009.
The VIX can be found through many free charting applications most commonly under the symbol VIX or $VIX or ^VIX. The growth in interest in the VIX has spawned other volatility indexes that track oil, gold, the EUR/USD exchange rate and other stock indexes. These are also very helpful and you will learn about them next.
The VIX can be used as an analytical tool to identify entry and exit opportunities or periods when market risk is likely to be higher or lower. This information is especially useful because it is not just another iteration of a price-and-time study but is derived from investor expectations for near term volatility. The VIX is obviously useful as a way to analyze the stock market indexes but in this article I will show that it can also be used to help identify opportunities in the inter-market environment.
[VIDEO] Predicting Volatility with the VIX – Part 2
The VIX has a propensity to channel, which can make analysis very easy. Channeling markets (like trending markets) are predictable and can be very profitable when they are consistent and extended. Technicians always struggle with the transition from a channel to a trend and vice-versa so the VIX’s tendency to channel for long periods is extremely convenient for a technical trader.
Within a channel support and resistance levels become triggers for entries and exits or as warnings that risk is rising or falling. In the chart below you can see an extended channel on the VIX from 2004 – 2007. When the index approached resistance, the stock market had a tendency to rally and it was an excellent timing signal for new entries. Conversely, when the VIX was bouncing off support and “fear” was beginning to rise covering
long positions in the stock market was a more prudent course of action. In the video I will walk through how those signals compared to the actual price action on the SPY (S&P 500 ETF.)
We recommend that you spend some time looking through the historical charts of the VIX and comparing it to a chart of the SPY or S&P 500 index. It should be clear how the VIX could have been used to identify buy and sell signals. Even when volatility is elevated beyond historical levels, these support and resistance bounces can be helpful. In the video I will illustrate how this analysis can be used within the current high-volatility market environment.
Although the VIX is based on the volatility of the S&P 500 index options, it can be useful as a general measure of investor sentiment in the intermarket environment. For example, forex traders are aware of a periodically strong correlation that the USD/JPY exchange rate has with U.S. equities. The bullish trend on the VIX in the 1st and 2nd quarter of 2009 has shown that USD/JPY shorts are at risk and that an extended trend to the downside is unlikely. The VIX can also be used to help forecast and analyze yield trends, bond prices and commodities. In the video above I cover an example of this kind of intermarket analysis.
We’ve talked about the VIX as one of the most effective technical indicators available to traders. The VIX can help you understand changes in risk, option premiums and market trends. The VIX is also a very interesting instrument for traders to profit from. You can essentially trade changes in the VIX through futures, options or ETNs.
[VIDEO] Predicting Volatility with the VIX – Part 3
The mechanics of executing a futures, options or ETN trade are not complicated and have been discussed thoroughly elsewhere on the Learning Markets website. If you need a little more explanation, I have included links to some excellent background information within the text of this article.
Although the order entry and analysis process for executing trades based on VIX instruments is relatively straightforward there are some very unique characteristics that you need to understand BEFORE you start making trades. In the video I will show you why the VIX’s tendency to “revert to the mean” creates these unique features.
There are futures contracts based on the VIX index available for traders with access to a futures trading account. VIX futures are probably not a good idea for novice traders or for traders with a small capital base as each point move in the future’s price is worth a $1,000 gain or loss per contract. However, if you are interested in learning more about this contract, click here to get the official scoop from the CBOE futures exchange.
There are index options based on the VIX available to traders with a standard stock and options brokerage account. You can buy or sell both calls and puts or create spreads, strangles or straddles like you would a traditional options trade. However, there are a few things to keep in mind when trading VIX options.
- Because the VIX tends to revert back to the mean, at-the-money calls and puts with the same strike price may have very different premiums. For example, if the VIX is very high everyone knows that it is more likely that it will begin to decline in the near term than rise further and this will make puts much more expensive than calls. The same is true in reverse.
- VIX calls and puts expire thirty days prior to the next month’s expiration of SPX index options. That means that they expire on the Wednesday before or the Wednesday after normal expiration Friday. This is not a problem for most traders but it can be confusing if you were expecting a Friday expiration.
- Option traders investigating VIX options for the first time may find time spreads (calendar spreads, diagonal spreads, etc.) appealing at first glance. However, this is because each month’s VIX options are based on a different month’s SPX index options expiration date. This distorts these spreads to look much more attractive than they really are. You can dig into the details of why this is and what the risks are but take our word for it and just don’t do it.
Exchange Traded Notes (ETNs) trade like stocks and can be a little easier to manage for new VIX traders than calls and puts. An ETN is very similar to an ETF and because it trades like a stock it can be added to the active-trading portion of your portfolio easily. Keep in mind that because all market participants know that the VIX tends to revert back from extreme highs and lows the movements of a VIX ETN will be somewhat less dramatic than the actual movements of the index.
Trading the VIX is easy to do if you are inclined to add it to your list investment strategies. It is easy to analyze and is negatively correlated to a very high degree with stocks, which creates an opportunity to diversify. However, remember that VIX investments have some unique characteristics that makes paper trading a must before jumping in and making live trades.