The VIX Index, officially known as the Chicago Board Options Exchange Volatility Index, is calculated using the prices of near-term and next-month options with expiration dates ranging from 23 to 37 days. It measures the expected 30-day annualized volatility of the S&P 500 Index.
Simply put, the VIX measures the implied volatility of the S&P 500 Index. A higher VIX value indicates greater expected market volatility. Given the importance of the S&P 500 Index, the VIX is often referred to as the "fear gauge" of the market, signaling potential risks.
The "Rule of 16" for Volatility
Investors can trade VIX futures and options directly. Despite its popularity, many investors do not fully understand how the VIX measures option volatility, its implications, and how to estimate its most accurate value.
Introduced by the Cboe in 1993, the VIX was initially based on the implied volatility (IV) of S&P 100 Index (OEX) options. In 2003, the calculation shifted to the more actively traded S&P 500 Index (SPX) options. Since its inception, the VIX has become a premier indicator of investor sentiment and overall market volatility.
According to the "Rule of 16," if the VIX is trading at 16, the estimated daily movement of the SPX is 1% (since 16/16 = 1). If the VIX is 24, daily volatility is approximately 1.5%, and if the VIX is 32, the SPX could see daily moves of about 2%.
How to Invest in the VIX?
The VIX has the potential for significant spikes, theoretically unlimited on the upside. During the extreme panic of the 2020 pandemic, the VIX surged above 80 in a very short time. However, the VIX is also highly volatile, with potential for sharp rises and falls, or prolonged periods of low levels. If a recent market pullback is short-lived, the VIX could present an excellent trading opportunity. Investment tools for the VIX include:
(1) ETFs/ETNs:
$iPath S&P 500 VIX Short-Term Futures (VXX)$: A single-leveraged ETN.
$ProShares Ultra VIX Short-Term Futures ETF (UVXY)$: A 1.5x leveraged ETF with relatively good options liquidity.
$2X LONG VIX ETF (UVIX)$: A 2x leveraged ETF with greater volatility and higher leverage decay.
(2) Futures:
Since ETFs/ETNs are composed of futures, they incur rollover losses over time, causing long-term declines in the index. VIX futures, on the other hand, do not have this issue. Thus, for long-term bullish bets on the VIX, buying VIX futures is more effective. For retail investors seeking speculative trades, ETFs like UVXY are a better choice due to their accessible options liquidity, enabling cyclic options strategies.
Trading Strategies for the VIX
For short-term VIX movements:
If the market is range-bound, rising, or slightly declining, the VIX will generally decrease.
Bearish Strategy: If you anticipate lower market volatility, consider selling call options, using a bear call spread, or shorting UVXY.
Bullish Strategy: If you expect increased market volatility, consider buying call options, using a bull call spread, or going long UVXY.
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