What is VIX and How do you Trade it?

Synopsis:
The VIX ("fear index") measures expected volatility in the S&P 500. It's a key tool for understanding market sentiment and potential risk. While you can't trade the VIX directly, you can use futures, options, and ETFs to hedge your portfolio or speculate on volatility changes.

Introduction to the VIX

VIX is a real-time volatility index created by the Chicago Board Options Exchange (CBOE). It shows how the market thinks the S&P 500 (SPX) prices will change in the next few months. This index is crucial in trading and investing because it assigns several values to market danger and buyers' feelings.

The level of volatility goes up when the price changes of the index are bigger and down when they are smaller. VIX is an index that traders can use to measure volatility. They can also trade VIX futures, options, and ETFs to protect themselves or bet on changes in the index's volatility value.

Why knowing the VIX is essential?

There is a strong negative correlation between VIX-linked products and the stock market. This has made them popular among traders and buyers who want to diversify, hedge, or speculate.

Investing in the VIX could help you balance out other stocks in your portfolio and reduce your risk of losing money in the market.

In this example, let's say you own a lot of stock in a US company that is part of the S&P 500. You think it will be a good investment in the long term, but you want to lower your risk of short-term instability. You decide to open a trade to buy the VIX because you think volatility will go up. In this way, you can balance these views.

If you were wrong and volatility didn't go up, wins in another trade could compensate for the losses in the VIX position.

How to trade the VIX?

Like all other stocks, the VIX can't be bought straight up. Investors can instead buy or sell VIX through futures or options contracts or exchange-traded products (ETPs) that are based on VIX. One example is the ProShares VIX Short-Term Futures ETF (VIXY). These funds invest in linked futures contracts and follow a specific VIX-variant index. The instrument is available on the Century Trader App.

VIX – SPX Correlation Chart

Based on daily percentage changes in the S&P500 and point changes in the VIX over a moving window of 252 trade days (about a year), the chart below shows how the two have been linked.

Using VIX to predict S&P 500 volatility

Since the S&P 500 tends to increase over time, buyers quickly buy insurance (put options) when the price decreases. This makes the VIX go up. Why is the VIX called a "fear barometer"? Because market participants often overshoot when the market goes down.

During market stress, the VIX's spike-like behaviour can help you tell when people are selling too much and the market is about to bounce back or even bottom for a longer-term move higher. Most of the time, this approach works best when the VIX "signal" happens during a usually rising trend in the S&P 500

How to interpret VIX Reading?

With this information, you can make intelligent choices about investments. Most of the time, when VIX prices are

There may be some confidence in the market and very little change when the number is between 0 and 15.

15 to 25: This could mean some fluctuation, but nothing too extreme.

25, 30, or more: This could mean the market is shaking and volatility is rising.

Thirty or more could mean the market is volatile and will soon change significantly.

The VIX is an index that can be watched and traded with various options and exchange-traded products. Investors can also use VIX numbers to determine the value of swaps.

Key takeaways

In short, if you want to trade equity indices, you must know about stock market volatility and the CBOE Volatility Index (VIX). Understanding how volatility works is helpful from both an academic and a risk management point of view. It will take some time and practice to get a feel for how the VIX and the S&P 500 relate to each other, but it will be well worth it.

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