What is the VIX? How to use the volatility index in your trades
Rebecca Cattlin June 16, 2021 10:08 AM
The VIX is one of the most widely-used measures of market volatility, for both the S&P 500 and wider stock market. So, what is the VIX, how is it calculated and how can you take your first position on volatility? Find out below.
What is the CBOE Volatility Index (VIX)?
The CBOE Volatility Index – more commonly known as the VIX – is a real-time index that tracks the market’s expectations of changes in the S&P 500. It’s an important benchmark for market risk, stress and sentiment, which is why it’s often referred to as the ‘fear gauge’.
The VIX was introduced in 1993 by the Chicago Board of Options Exchange. It’s grown over the years, and its calculation methodology has been altered to create a broader market benchmark and more accuracy.
How does the VIX work?
The VIX works by tracking the price of at-the-money SPX options with near-term expiration dates. This means it’s not a representation of the price of the underlying S&P 500 itself, but of the price traders are willing to buy and sell the S&P 500 at for the next month. The more dramatic the price swings in the value of SPX options, the higher the levels of market volatility and so the higher the VIX value.
SPX options are a combination of standard SPX options that expire on the third Friday of each month and weekly SPX options that expire on all other Fridays. To be included, an option must have an expiry date between 23 and 37 days from the time of calculation.
The VIX calculations are complex, so put simply, the index takes the values of all of the put and call options over a range of strike prices and deduces the market’s perception of which strike prices are likely to be hit before the expiry date from how much people are willing to pay for each option.
The VIX is calculated in real-time from 8 am to 2:15 am (UTC) and from 2:30 am to 9:15 pm (UTC).
What does the VIX tell us?
The VIX tells us the market’s expectation of volatility, rather than current or historic market levels. However, it is considered a leading indicator for the wider stock market.
A common mistake when reading the VIX is that it tells us whether the S&P 500 is being bought or sold. While the VIX and S&P 500 do usually have an inverse relationship, the VIX is a measure of volatility itself – and in theory these price movements could go both ways.
Another common misconception is that VIX levels have an exact relationship with the volatility seen 30 days later, when in reality the VIX level is often slightly above – or trading at a premium to – the actual volatility. This is because when the time comes around, the market has usually adjusted to the volatility.
How do you read the VIX?
The VIX is presented as percentages, so the indicator fluctuates between 0 and 100, much like a typical oscillator. You read the VIX using known levels of support and resistance; these are:
- Below 12 = low volatility
- Between 12 and 20 = normal volatility
- Above 20 = high volatility
There’s been a traditional mantra of ‘When the VIX is high, it’s time to buy. When the VIX is low, look out below’ – which is used to describe these support and resistance levels.
What does it mean when the VIX goes up?
When the VIX goes up in value, it means the price of S&P 500 is likely falling and the value of SPX put options are increasing.
Analysts interpret these high values to mean that investors are uncertain or fearful about the stock market. The theory goes that when there are high levels of volatility in the market, a bottom or support level has been found and the market is going to change direction. This is why the common action is to buy with the VIX reaches high levels.
What does it mean with the VIX goes down?
When the VIX falls in value, it usually means that the price of the S&P 500 is rising in price or experiencing relative stability – leading SPX options investors to pursue bullish or neutral strategies.
Analysts would interpret these low to middle values as a sign that the market is experiencing little stress or concern. Low VIX values are often bearish signals, and lead to market participants closing their positions.
How do you use the VIX?
You can use the VIX as part of a trading strategy as it can give indications of whether the S&P 500, and stock market in general, is going to reverse from its current trend.
As mentioned above, when the VIX hits highs, it’s often seen as a time to buy the market, and when it makes lows, it’s seen as a bullish signal. However, this strategy should be taken within a wider methodology of technical and fundamental analysis to confirm the entry and exit points the VIX suggests.
It’s important to note that the VIX can remain above or below these levels for significant periods of time, so the signals it gives off might not necessarily indicate an immediate reversal. For example, when the COVID-19 pandemic hit in early 2020, the VIX climbed higher than 80 – a level it hadn’t experienced since the last financial crisis in late 2008. It took the VIX until December 2020 to fall below the 20 mark again.
The key thing to remember is just that the VIX and the S&P 500 have an inverse relationship, so when the VIX is rising or falling, the S&P will likely be doing the opposite. This makes the VIX a popular hedging tool.
How to trade the VIX
Take a position on whether the VIX is rising or falling in four easy steps:
- Open an account with FOREX.com or log in to your existing account
- Search ‘Volatility index’ in our award-winning platform
- Choose your position and size, and your stop and limit levels
- Place the trade and monitor the market
Alternatively, you could practise trading the VIX in a risk-free environment first, using our demo account.
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