To The Moon

What Is the VIX?

The volatility index, or VIX, is one of the most common barometers of market sentiment. For traders, the VIX not only represents a useful tool for assessing risk, but also the opportunity to capitalise on volatility itself. The VIX index is a well-known and widely-followed index that helps traders measure the levels of fear and greed in the market.

The VIX is a real-time volatility index, created by the Chicago Board Options Exchange (CBOE). It was the first benchmark to quantify market expectations of volatility. But the index is forward looking, which means that it only shows the implied volatility of the S&P 500 (SPX) for the next 30 days.

The VIX is calculated using the prices of SPX index options and is expressed as a percentage. If the VIX value increases, it is likely that the S&P 500 is falling, and if the VIX value declines, then the S&P 500 is likely to be experiencing stability.

The volatility spike during the Pandemic 🚨

While the VIX only measures S&P 500 volatility, it is commonly used as a benchmark for the entire US stock market. The price of options is considered a good measure of volatility as if something concerns the market, traders and investors tend to start buying options, which causes prices to rise. This is why the VIX is also known as the fear index, as it measures the level of market fear and stress.

The current volatility cannot be known ahead of time, so the VIX is best used in tandem with historical analysis of support and resistance lines.

How Is The VIX Calculated?

The VIX is calculated in real time using the live prices of S&P 500 options – this includes standard CBOE SPX options, which expire on the third Friday of every month, and weekly CBOE SPX options that expire every Friday. To be considered for the VIX index, an option must have an expiry date between 23 and 37 days.

The basic theory of the calculation is that by combining the weighted prices of multiple S&P 500 put and call options over a wide range of strike prices, we can gain insight into what prices traders are willing to buy and sell the S&P 500 at. These final values will estimate the future volatility of the S&P 500.

When Is A Good Time To Trade The VIX?

When you open a position on the VIX, there are two basic positions that you can take: long or short. It is important to remember that volatility traders are not interested in whether the price of the S&P 500 is going to rise or fall, as they can capitalise on both – they are instead looking at whether the market is volatile.

Traders who go long on the VIX are those that believe that volatility is going to increase and so the VIX will rise. Going long on the VIX is a popular position in times of financial instability, when there is a lot of stress and uncertainty in the market.

When you take a short position on the VIX, you are essentially expecting that the S&P 500 is going to rise in value. Short-selling volatility is particularly popular when interest rates are low, there is reasonable economic growth and low volatility across financial markets.

⚠️ Top VIX Trading Strategies

Strategy #1: Trading VIX Volatility

One of the most popular strategies to trade the VIX index is to trade its volatility with the use of some basic technical indicators. In this strategy, we’re using Bollinger Bands and moving averages to determine entry and exit points for our trades.

Bollinger Bands is a volatility indicator that plots a channel two standard deviations away from a moving average. In this example, we’re using the standard Bollinger Bands settings with a 20-period MA.

The following chart shows the VIX short-term futures ETF with Bollinger Bands applied to it. The green arrows indicate possible buy signals, and the red arrows possible sell signals.

The rules of the strategy are as follows:

1. Wait for the VIXY to reach the upper or lower channel of the Bollinger Bands. The upper channel sends a sell signal, and the lower channel sends a buy signal.

2. To confirm our entry, zoom into a lower timeframe, and wait for the moving average to confirm the trade. The MA should move downwards on the lower timeframe when the VIX reaches the upper channel on the higher timeframe to confirm a sell trade, and vice-versa.

3. Our profit target is set at the centre of the Bollinger Bands (the 20-period MA).

4. Stop-loss orders can be placed just above (below) the Bollinger Band.

Strategy #2: Trading VIX Reversals

Another popular VIX trading strategy is the Reversal strategy, which takes advantage of the mean-reversion characteristics of the index. The strategy uses a similar approach to the volatility strategy, with the difference that all trading decisions are based on moving averages, and that there’s always going to be an open trade in the market.

For this strategy, we’ll use two moving averages. The faster MA has a 5-period setting, and the slower MA a 15-period setting. The following chart shows how the VIX index chart looks like with the MAs applied to it. Again, the green arrows signal possible buy setups, while the red arrows signal possible sell setups.

Here are the rules of the Reversal strategy:

1. Wait for the faster 5-period MA to cross above the slower 15-period MA to open a buy trade.

2. When the 5-period MA crosses below the 15-period MA, it’s time to close the buy trade and immediately open a sell trade.

3. When the 5-period MA crosses above the 15-period MA again, it’s time to close the sell trade and immediately open a buy trade.

4. Stop-losses are placed just above the recent swing high for sell signals, and just below the recent swing low for buy signals.

Strategy #3: Trading VIX Divergences

The third VIX trading strategy involves trading divergences between the index and the underlying stock index. Since the VIX index derives its value from the implied volatility of S&P 500 options, it’s no wonder that both instruments are closely correlated. A rising VIX usually means a falling S&P 500, and vice-versa.

The VIX Divergence strategy aims to take advantage of the relationships between the VIX index and stock indices.

The rules of the VIX strategy are explained below:

1. A falling VIX index combined with a falling S&P 500 is a bullish divergence. This increases the odds of an upside reversal.

2. A rising VIX index combined with a rising S&P 500 is a bearish divergence, signalling a possible downside reversal.

3. A falling VIX index combined with a rising S&P 500 is a bullish convergence, signalling further strength in the S&P 500 and/or weakness in the VIX.

4. A rising VIX index combined with falling S&P 500 is a bearish convergence, signalling further weakness in the S&P 500 and/or strength in the VIX.

How To Use VIX To Trade SPY?

For the past several years, if the VIX was trading below 20 then the market was considered to be in a period of stability, while levels of 30 or more indicated high volatility.

The VIX is thought to predict tops and bottoms in the SPX: as it reaches extreme highs, this is seen as a sign of impending bullish pressure on the S&P 500, and as it reaches extreme lows it is seen as bearish for the S&P 500. There is even a mantra that states: when the VIX is high, it’s time to buy. When the VIX is low, look out below.

Like all indices, when you trade the VIX, you aren’t trading an asset directly because there is no physical asset to buy or sell. Instead, you can trade the VIX by using derivative products that are designed to track the price of the volatility index.

VIX High at Lehman Bros & The Pandemic

Having said the above, most traders use VIX as a guide to confirm the price action of S&P 500. Since other move counter directional of each other, use the VIX as a confirmation to enter or exit SPY or SPX will be helpful.

To trade the divergence strategy, simply add two charts to your trading platform (VIX and S&P 500) and closely follow the price action of both instruments. Do bear in mind that the VIX can be very volatile at times, so try to use stop-losses in all of your trades.

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