CBOE Volatility Index (VIX) Definition & Strategy
The VIX index is a popular measurement for traders to quickly judge market volatility. It also provides trading opportunities, with some traders using it to diversify their portfolio or others as an effective hedging tool. Keep reading to discover how the VIX volatility index works and how to trade on it.
What is the VIX volatility index and how does it work?
In this article, you can discover what the VIX volatility index is and how it works. Following this, we will look at how you can trade the VIX volatility index and key considerations when doing so.
What is the VIX index?
The VIX volatility index (VIX^) is a real-time market index that measures the stock market’s expectation of 30 day forward-looking market volatility. It was created by the CBOE, or the Chicago Board Options Exchange. The indexes value is derived from the price inputs of the S&P 500 options, therefore representing the expectation of market risk and volatility.
The VIX volatility index is known by other terms such as the ‘Fear Gauge’ or ‘Fear Index’. For investors, the VIX index provides an efficient method to judge market risk, fear and uncertainty when making trading decisions.
How does the VIX volatility index work?
CBOE’s volatility index was designed to measure the market’s expectations of volatility; it achieves this by using option prices from the S&P 500. By judging how far the put and call prices are distributed from the current price of the S&P 500, the volatility index draws an average, which is represented by VIX’s current price.
Most indexes are calculated based on stock prices, but the VIX volatility index is instead based on the S&P 500’s option prices. The calculations are complicated but result in a measure of market outlook and volatility for the following 30 days.
The VIX cannot be directly traded, but many traders use ETFs or ETNs that are tied to the VIX to gain exposure to it. Additionally, besides trading the VIX, many investors have adopted it as a useful say on market volatility. It is also used as the backbone to many products that are based on volatility indexes.
Analysing the VIX volatility index during COVID-19
The VIX index fluctuated during the coronavirus crisis to levels that had not been since the financial crisis of 2008. This resulted in a number of ETFs and ETNs that track the VIX index to jump wildly in price. Some of these indexes were leveraged, resulting in even sharper fluctuations and providing riskier opportunities for profits and losses.
During March 2020, the VIX index — which charts the 30-day implied volatility of the S&P 500 based on index options — went above $82, an all time-record that exceeded the $80.86 recorded in late 2008. In the days that have followed however the index dipped reaching a level of 56.14 one month later.
Despite the recent dip, for those searching for volatility, the index has generated many opportunities during the coronavirus pandemic. Furthermore, the iPath S&P 500 VIX Short-Term Futures ETN [VXX] — designed to offer exposure to VIX futures contracts — rose by 391% from the 20th February to the 18th March, before dropping again.
For those interested in volatility trading with a higher appetite for risk and who want even greater exposure to the index, the ProShares Ultra VIX Short-Term Futures [UVXY] grew by more than 880% over the same three-week period. This ETF provides leveraged exposure to the S&P 500 VIX Short-Term Futures Index.
Furthermore, since the start of the year, the VelocityShares Daily 2x VIX Short-Term ETN [TVIX] — which provides a two-times leveraged exposure to an index comprised of first- and second-month VIX futures positions — has climbed 664% since the start of the year, according to Reuters, peaking at the 806 level on the 18th March, up 1712% YTD at that point.
Trading the VIX volatility index
Although the VIX index cannot be directly traded on, several indexes track the VIX index and can be traded on. When trading on the NG platform, you can access the ProShares VIX Short-Term Futures ETF, which is a popular ETF that provides exposure to the S&P 500 VIX Short-Term Futures Index. This index measures the returns of a portfolio of monthly VIX futures contracts with a weighted average of one month to expiration.
The ProShares VIX Short-Term Futures ETF is designed for advanced investors who wish to profit from the S&P 500’s volatility. This volatility is measured by the prices of VIX futures contracts.
Intended for short term leveraged trading, the ProShares VIX Short-Term Futures ETF can work as an effective hedging instrument to the S&P 500
How to trade on the VIX index
- Research your chosen asset. Make important decisions based on your market research such as which direction to place your trade, your market entry points and your position size.
- Consider risk management. Having a plan when trading can reduce the likelihood of making irrational decisions. Additionally the use of stop-loss and take-profit orders can help mitigate your exposure to risk.
- Place you VIX index trade. Open an order ticket and fill out the appropriate fields. Place you trade and track its performance - make sure to close your position when you are ready.
Key considerations when trading the VIX volatility index
- Watch the use of leverage when trading ETFs. Leveraged ETFs are complex financial instruments that carry significant risks and certain leveraged ETFs are only considered appropriate for experienced traders.
- Manage your risk. When leveraged trading you can make substantial profit but can also make large losses. You can automate parts of your trading and manage your risk exposure with the use stop-loss and take-profit orders.
- Research, and then research some more. Knowing how an asset works and what it is influenced by can give you a large advantage when trading markets. In this case, the more you know, the better.
When market fear is high, so is the price of the VIX index. Whereas, a lower VIX can be a sign of either greed or investor complacency. Using the VIX alongside other measures of volatility and market outlook can help to provide crucial clues into current investor sentiment and an indexes outlook.
Finally, the VIX volatility index is just a single model of volatility. Combining multiple models and inputs in your trading can provide you with less risk exposure when compared to betting on a single variable.
Source: CMC Markets UK