The VIX (Volatility Index) is a high-quality real time sentiment tool for equity traders. While the VIX behaves similarly to an index, trading it is not as straightforward. Knowing what the VIX is, what it does, and how to implement it into your equity trading strategies can provide an essential factor in trading.
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I will explain the VIX to help traders decide if and how they can benefit from it, how to interpret it, and tips on how to trade it.
What Is the VIX?
The volatility the VIX measures is ‘implied volatility,’ the calculations use S&P 500 Index options pricing data itself derived using the Black-Scholes formula. The VIX has an inverse correlation to the S&P 500 Index, meaning a rising VIX suggests a falling S&P 500 Index and vice versa.
While the VIX measures volatility, which most traders associate with higher risk and market declines, volatility is market neutral. Volatility is a statistical measure of the price action of an asset, and higher volatility translates into more substantial price movements in either direction over a brief period.
Therefore, volatility is neither positive nor negative but rather an indicator of the magnitude of price action. Traders can use the VIX and its inverse correlation to the S&P 500 Index to assess if the magnified price move is to the upside, suggesting volatility friendly strategies like breakout trading, or to the downside, implying low volatility strategies might work best.
How Is the VIX Calculated?
The formula is complex but knowing some core components can help understand how the VIX measures implied volatility.
Below are some facts traders should know about the VIX calculation:
- The VIX uses S&P 500 Index put and call options with more than 23 days and less than 37 days to expiration, which creates interpolation of two points along the 30-day S&P500 volatility spectrum.
- The VIX uses near-term options (close to but above 23 days to expiry) and next-term options (close to but less than 37 days to expiry), combining both results for more stability and accuracy in the VIX.
- The VIX only uses S&P 500 Index at-the-money (ATM), and out-of-the-money (OTM) put and call options.
How to Trade the VIX
Traders have four choices in trading the VIX, which I will cover below. Besides trading the VIX, it can serve as an indicator of how to position an equity portfolio. Some prefer using the index as a hedge due to its inverse correlation to the S&P 500 Index.
Four Ways to Trade the VIX
1. VIX futures contracts: The VIX measures implied volatility over 30 days, but trading VIX futures can result in contango, making them viable for ultra-short-term and intra-day trading. Contango refers to the futures contract trading above the current spot price, resulting in traders always buying high and selling low.
2. VIX options contracts: VIX options are European-style options meaning traders can only exercise them on maturity dates should they choose to do so. Therefore, they are not ideal for capturing potentially rapid changes in implied volatility.
3. VIX ETFs: One of the most-used methods of volatility exposure is via ETFs (Exchange traded fund), but the performance can result in similar issues to VIX futures. Therefore, traders should minimize their VIX exposure to intra-day trading, where the performance discrepancies, if they appear, remain smaller. The ProShares VIX Short-Term Futures ETF (VIXY) ranks among the most actively traded VIX ETFs.
4. VIX ETNs: Aggressive traders who can stomach 10%+ moves can consider the iPath B S&P 500 VIX Short-Term Futures ETN (Exchange traded note, VXX). It measures a daily moving long position in VIX futures of the first and second months. Most traders in this ETN understand that it is not ideal for long positions despite its inverse correlation to the S&P 500 Index.
Additional things to consider when trading the VIX:
- Some VIX-related instruments have comparatively thin liquidity.
- Just because a trading instrument has the name VIX included does not make it an accurate representation of the VIX or implied volatility.
- Buy-and-hold strategies are pointless with VIX.
- VIX trading can result in massive volatility.
- Many retail brokers do not offer VIX-related assets.
A better use of the VIX for most traders is using its inverse correlation to position portfolios. A rising VIX suggests equity prices may fall and vice versa.
Can you trade the VIX directly?
No, the VIX is an index, and traders cannot trade it directly but via futures contracts, which can create potential long-term issues, like contango, options, which are European-style options not ideal for trading VIX price action, exchange-traded funds (ETFs), or exchange-traded notes (ETNs).
How to use VIX in stock trading?
Four of the most-used approaches to incorporate the VIX are taking the current VIX level to determine market volatility, comparing ratios of the current level to long-term averages, using it as a hedge, primarily for S&P500 positions, or trading price action on an intra-day basis.
What is a VIX trading strategy?
A VIX trading strategy is any strategy using the VIX. Most VIX strategies are intra-day strategies using technical analysis and algorithmic trading solutions.
Can you buy and sell the VIX?
Traders cannot buy or sell the VIX directly but via futures contracts, ETFs, and ETNs.
Is there a stock that tracks the VIX?
No stock tracks the VIX, but ETFs and ETNs track VIX futures, which can create challenges unless traders use it for intra-day trading purposes.