What is the VIX? It’s also known as The Fear Index. With so many indicators out there, would this be one to add? Trading the stock market is fun to think about. When times are tough, knowing how to trade can be extremely beneficial. As a result, many people jump on the trading bandwagon.
Many think they’ll get rich quickly, but it doesn’t turn out that way. So what if there’s a way to help measure volatility? It’s one of the best gauges of market deep-rooted concern and one of the most closely watched measures of market volatility.
If you follow the stock market, you have undoubtedly heard about the VIX Index, commonly called the fear gauge of the markets. The actual name of the VIX is the CBOE Volatility Index. It’s the ticker symbol that can be traded and tracked.
Why? Because it measures the volatility of the financial markets, spikes in the VIX usually indicate a volatile day of trading on Wall Street. This article will discuss the index, its measurements, and why it matters to stock traders worldwide.
It was founded in January 1993 by the CBOE, or the Chicago Board Options Exchange. It’s important to note that it measures expectations and is a forward-looking mechanism. Just because it spikes does not necessarily mean things will be volatile.
VIX CBOE Volatility Index Introduction
How is the VIX measured? The readings are taken from the perceived price changes in options contracts for the S&P 500 index. After reading the price changes in the near-term options contracts, it provides a 30-day forward-looking market volatility prediction. Generally speaking, the higher the VIX reading, the greater the market’s fear.
The Volatility Index measures differences between prices on future calls and puts. If call options are being purchased for dates several months in the future for wildly varying prices, the VIX should have a high number, typically in the twenties or thirties.
If calls are trading at similar prices (not necessarily the same as the current stock prices), it should have a low number in the single digits or teens. Interestingly, the market reacts to the same information the VIX reacts to, in that days when the market swings correlate with days when it’s high.
This article attempts to answer three major questions about the VIX index. First, how reliable is the VIX? Specifically, can an index that measures unpredictability reliably measure it? Is there a difference between predictably unpredictable, unpredictable, and very unpredictable?
Second, how useful is it? Specifically, does a change in the VIX index provide enough information to take action in the market? Or are changes in the VIX priced immediately?
Finally, how would one use the VIX index to adjust strategy in day trading? If it’s reliable and useful, does it have applications to patterns?
What Is Volatility?
When we hear about market volatility, we think of price fluctuations and sudden green or red days. But what does volatility truly mean for the stock market? Volatility measures the variation in the price of an asset over time. In this case, it refers to the price fluctuations of the S&P 500 options contracts. If those contract prices are volatile, then it is implied that the rest of the market will be volatile, too.
It isn’t just the concern over dropping stocks that causes fear and volatility. A long list of factors, including economic events, geopolitical tension, general market sentiment, and company earnings reports, can cause volatility. It’s one reason why traders monitor the VIX index. It can consider catalysts that you might not have heard about yet.
Volatility is a statistical measure of the degree of variation in the trading price of a security (e.g., a stock) over a specific period.
Likewise, the more dramatic the price swings in that instrument, the higher the level of volatility, and vice versa. Although volatility can keep even the calmest investors up at night, it can be a day trader’s dream. As you know, day traders—scalpers especially—thrive on short-term price swings. A 1000 shares at $0.20 profit here and there adds up.
But these swings don’t happen unless there’s a trigger, like mass panic due to a virus. Without swings, you can’t make money.
VIX CBOE Volatility Reliability
What does reliability mean? Naively, if the VIX index is low, one would expect the market’s volatility to be low for several months.
If the index is higher, future volatility is expected to be limited. If it is very high, extreme volatility is expected.
Since it measures future chaos, one would want it to be reliable. However, chaos is inherently unpredictable, so it is not overly reliable.
To test reliability, we look at three ranges of values for the VIX:1. 0 < VIX < 152. 15 <= VIX < 193. VIX >= 19
We hypothesize that average market volatility in the six months succeeding a measurement will be very limited for case 1, limited in case 2, and unlimited in case 3.
If not rejected, the hypothesis will supply specific volatility measurements that we may be able to use in trading.
Background on the VIX
The Chicago Board Options Exchange (CBOE) created the VIX, a real-time market index representing the expected volatility over the next 30 days.
We can measure market risk and investor sentiment using the price inputs of the S&P 500 index options.
You might also have heard it called the “Fear Gauge” or “Fear Index.” It’s considered to be the leading indicator of the U.S. stock market.
How to Calculate Volatility With the VIX
Keeping track of the VIX is enough for most traders to understand market volatility. A sudden surge can cause wild fluctuations in the price of stocks or options contracts. If you are monitoring the markets, it always helps to have one eye on the VIX Index.
It is quite a complicated mathematical formula if you want to know how the reading is calculated. We’ve provided a simplified example of the factors the CBOE considers when calculating the reading.
How the CBOE Calculates the VIX
- The CBOE selects various S&P 500 options, including calls and puts with varying strike prices and expiration dates. Typically, these expiration dates are near-term and expire within the next 30 days.
- These selected S&P 500 options contract prices are recorded.
- Then, it is plugged into a formula that prices option contracts. One example is the Black-Scholes model, commonly used to value option contracts.
- This calculates the price of the options contract and their relative value compared to the current price of the S&P 500 index. This is usually referred to as weighted volatility.
- The formula will provide the VIX Index reading. This is a real-time, forward-looking reading and more of a projection than the end-all be-all of financial metrics.
What Do the VIX Readings Mean?
Okay, so we have a reading from the index. What does it all mean? VIX readings can range from 0 to infinity, so it is important to know exactly how volatile a specific reading is. Since the VIX was founded in 1993, we only have recent market crashes to document. The highest-ever VIX close was 82.69 on March 16th, 2020, during the COVID-19 crash. Here is a rough look at what each VIX range means to the markets.
Low VIX Volatility (0-20)
For the most part, the VIX lives in this range. A low reading usually means the market is stable, and future volatility will be tame. There isn’t much fear at this point, and the next 30 days appear fairly neutral according to the S&P 500 options prices calculation.
Moderate VIX Volatility (20-30)
While there is nothing to be concerned about, some fear is creeping into the markets. A VIX of over 20 signals that there will be some uncertainty about the market’s performance soon. It does not mean a crash is imminent; some things on the horizon could impact the markets.
High Vix Volatility (30-40)
The market is very fearful at a high VIX volatility reading. At this point, the market anticipates a sharp move in either direction, but usually implies a lower move.
Extreme VIX Volatility (40+)
It’s a VIX reading you don’t want to see too often. An extreme VIX score usually means major market disruptions and a financial crisis break. It could also mean that there are geopolitical events, like a potential war. At this point, traders are risk-off, which is usually a bearish time for the market.
What Does a Low VIX Mean?
When the VIX is low, SPX options are cheap because traders expect very little volatility in the next 30 days.
And since stocks tend to fall a lot faster than they rise, it can be assumed that when traders expect low volatility, they expect stock prices to rise.
What Does a High VIX Mean?
When the VIX is high, options traders expect a lot of volatility, which leads to falling stock prices. This translates into people paying a higher-than-normal premium to protect themselves against a downward stock move.
So, it accurately measures the fear expressed by options market participants at that moment.
The index can be used in contrarian investing, according to the adage “buy when there’s blood on the streets “… as long as you’re sure there’s not going to be more blood on the streets tomorrow, of course.
As the saying goes, buy the dip, but don’t try to catch a falling knife. Otherwise, your blood will be on the streets.
Easiest Way to Measure Reliability
The easiest and most standard way to measure reliability is by measuring combined returns. We took the ending monthly values of the VIX from January 1990 through September 2019; since we’re looking at several months of future activity, daily swings in the VIX would not matter.
Then, the combined monthly returns of the S&P 500 for the same period are taken. We created a data set comparing returns to volatility in six-month periods, looking out six months from each month to select and normalize combined returns of the S&P to each VIX category, generating several thousand data points.
We hypothesized that the VIX category would not predict combined returns.
Regressing normalized combined returns against VIX categories revealed that the coefficients of the categories were significant, with a confidence level of 95% or higher.
Thus, we could reject the hypothesis and proceed under the assumption that VIX values above 19 correlate with different combined returns than VIX values between 15 and 19 (VIX values below 15 were assumed to have little to no market volatility and were ignored).
What Is the VIX Usefulness?
The hypothesis test has also answered the question of usefulness. While volatility predicted by the VIX is probably priced immediately by the market, the fact that the hypothesis was rejected indicates that not all the volatility is priced immediately.
Therefore, opportunities to profit exist for several months after a change in the VIX. You can also use the TTM Squeeze to make quick trading decisions.
Is the VIX a Leading Indicator?
Applicability
A pattern screener uses several parameters to decide if a pattern is present (or likely to be present) in stock prices. For example, an ascending or descending channel is defined by the distance between the trend lines, the number of breakouts, the entrance criteria to the pattern (when prices begin to move within the trend lines), and the exit criteria (when prices have diverged far enough from the trend lines to be called an exit).
If you were to look at several months of stock prices and apply a particular pattern screener, you would identify several instances of the pattern in the data.
If you take the very same data and adjust the prices to reflect an increase in volatility while still maintaining the general trends of the data, the screener ought to find fewer instances of the pattern because:
- More breakouts will appear to exit because breakouts will occur more often, move further above or below the trend lines, and fail to match the screener’s breakout parameters.
- The trend lines will be further apart, failing to match the screener’s parameters.
- The entry points may not be identifiable to the screener since the trend lines are further apart.
- The exit points may be prematurely identified (really breakouts).
Thus, if the VIX were to increase today, the number of patterns identified by screeners would be reduced, and with the same number of traders trading the stocks, these patterns would be overtraded and less profitable.
The obvious suggestion is to react to a change in the VIX by modifying your screener parameters to pick up the patterns that would not be found and trade those patterns.
Parameters
For example, suppose the VIX goes up a given percent, and you start a new screener, adjusting the parameters accordingly. You then run the old and new screener in parallel.
Any pattern found by the new screener, not the old, will likely be thinly traded and more profitable.
Given a particular change in the VIX, how would you adjust the parameters? Since pattern trading is stock-specific, index changes will manifest differently in individual stock prices. We recommend the following approach:
First, select stocks of interest to you. Then, grab several months of price data and calculate Excel’s monthly (or daily or weekly) standard deviation. In a second column, get several months of VIX values (actual value or change in value) and compare the volatility of your stock to the VIX.
The result you want to calculate is: for any given value or change of value in the VIX, a likely standard deviation in price changes in your stock. It doesn’t have to be scientific. A blue-chip stock will have fewer price swings than a small-cap stock, and you merely want to understand how much your stock price moves instead of the overall market.
Then, select a period in the past, look at the VIX, select a period in the future, and decide on your stock’s likely volatility.
Trading the VIX
Like all indexes, one cannot buy the VIX directly. However, we know that money is to be made in volatile markets. CBOE realized they could make money if they captured volatility and packaged it into a tradable product.
They delivered. In 2004, the first VIX-based exchange-traded futures contract was created. Shortly after that, VIX options were launched, paving the way for users to utilize volatility as a tradable asset.
Many active traders, large institutional investors, and hedge fund managers use VIX-linked securities to diversify their portfolios. History demonstrates a strong negative correlation between volatility and stock market returns. In other words, when stock returns go down, volatility rises, and vice versa.
The most common way to trade the VIX Index is through options contracts. As with the S&P 500 (SPX) and other indexes, you cannot buy and hold the VIX in your portfolio. You can trade assets related to the VIX, such as options or futures. The options for the VIX are cash-settled, which means you are not assigned shares if your trade loses. The funds from the trade will automatically be removed from your account.
Other assets are tied to the VIX, including several ETFs like the ProShares VIX Short-Term Futures ETF (BATS: VIXY). For ETFs, you can buy shares, but know you are not holding the VIX itself; it is a fund that trades and holds VIX futures contracts.
Are you interested in getting into the game? Why don’t you check out ProShares VIX Short-Term Futures ETF (VIXY) or iPath Series B S&P 500 VIX Short-Term Futures ETN (VXXB)?
How to Use the VIX Index
The VIX is not just a projection of future volatility. Traders can use it as an asset and tool in various ways. Here are a few ways to use the VIX Index in your portfolio.
Risk Management
First and foremost, the VIX should be used to calculate future risk. It should always be something active traders follow, as it can usually provide a nice insight into the direction the markets are about to go. Use the VIX as a way to hedge against long-term portfolio holdings.
Option Price Accuracy
The VIX is a great tool for options traders because it allows them to accurately price options. VIX readings can be used in options pricing formulas like the Black-Scholes model mentioned above. It can be a great way to see if options contracts are underpriced or overpriced when considering expected future volatility.
Contrarian Indicator
If you think about it, the VIX is the ultimate contrarian indicator. They usually swing too far in that direction when oversold or overbought markets. If the VIX spikes, it is usually followed by a market decline. You can use this to your advantage and carefully buy when volatility is higher.
Economic and Market Analysis
The VIX is also a great way to gauge the health of the financial markets. Analysts and institutional investors use the VIX daily to measure fear or complacency. You can use this to your advantage to get the same market picture as professional traders.
VIX CBOE Volatility Example
For example, suppose my stock symbol is ABC, and its average daily standard deviation is 9%. But I’ve decided, based on the recent values of the VIX, that the likely standard deviation shortly may be closer to 18%.
This is the same as predicting that breakouts will be twice as big (18% divided by 9% = 2) and trend lines will be further apart by 9% (18% – 9% = 9%). Exits will naturally need to be larger than breakouts.
If I take my standard screener for, say, an ascending or descending channel, create a new screener with the new parameters, and run both in parallel, choosing only the patterns found by the new screener, it’s likely that
a) such patterns will exist (you did the calculations, after all), and b) fewer traders will trade the new patterns,
Leaving you with less competition at those particular points in time for trading the stock.
Key Takeaways
- The CBOE Volatility Index, or VIX, is a real-time market index representing the market’s expectations for volatility in the next 30 days.
- We use the VIX to measure the market’s risk, fear, or stress level to make investment decisions.
- Day and swing traders can also trade the VIX using various instruments, such as options and exchange-traded products.
- A high VIX indicates pessimism by option traders.
- The more panic in the market, the bigger the VIX spike. So, if the market suddenly drops in an hour, the VIX likely will spike.
Final Thoughts: What Is the VIX?
As you can see, the VIX Index is a tool that belongs in every trader’s arsenal. It is an integral reading of the financial markets and provides insight into what traders say about the next 30 days.
VIX spikes generally lead to market volatility to the downside and can often front-run stocks or indexes. It gives you a nice advantage over the perceived direction of the markets before it even happens!
When the VIX rises, stock prices decline because traders and investors use it to hedge their equity positions. As the VIX continues to soar, economic uncertainty continues. But we know uncertainty brings volatility, which means money is to be made. Where the VIX will go is anyone’s guess.
The VIX is a great leading indicator of volatility in options. Options are also a great way to grow a small account. You’ll do much better when you learn how to use the VIX in trading.
Frequently Asked Questions
Most, if not all, traders have heard of the VIX. But did you know it was called the fear index? Volatility moves markets. And fear causes that volatility. It can be detrimental if you don’t know when volatility will hit. As a result, having a fear index and knowing how to read it is extremely helpful.
The fear index is also known as the VIX. So what does that mean? The VIX is also known as the volatility index. Since traders thrive on volatility, this is a way to measure it in stock market trading.
