The VIX, also known as the 'Fear Index', is the symbol for the Chicago Board of Option Exchange's (CBOE) Volatility Index. Aside from the actual market indexes (Dow Jones, S&P 500, Russell 2000 and Nasdaq) the VIX probably ranks second for most watch index by investors.
It's movement is used to judge how much fear is priced into the market. Since most traders do not fear a market move to the upside the fear is all towards the downside and how much further the market will move lower.
Volatility is never an easy-to-read cut and dry indicator. There are many factors that go into understanding volatility so we must begin to look at each one before we can have an idea of future market direction. In this VIX primer we are going to talk about how you can trade the VIX, how to use it for an intraday and daily indicator, and a little on VIX futures. We can have an in-depth article on each of these topics but we must start somewhere.
What Is The VIX
The VIX had humble origins before becoming the leading volatility index. Started in 1993 the CBOE designed the VIX to measure the market's expectation of 30-day volatility on the S&P 100 using at-the-money options.
In 2003 the VIX formula got revamped. Instead of focusing on S&P 100 at-the-money options it is now based on the S&P 500, and takes account of options on a wide variety of puts and calls.
The actual formula used to calculate the VIX is both complicated and really unnecessary to know. Some of the things we should know is that the formula uses options that have more than 23 days and less than 37 days to expiration. The idea is to generate a 30-day implied volatility so prices are pulled in from a variety of series and options. With the inclusion of SPX Weekly options it is now easier for them to calculate this number. They will also take two expiration dates, a near-term and a further out term. Typically, once a week, they will need to roll their expiration dates. Now the further out term becomes the near term and a new further out term is selected, again under 37 days.
When selecting strikes used for the formula the focus is on out-of-the-money options only. They start at the at-the-money strike and move lower (for puts) including the mid-price of each strike until they reach a strike with a bid of $0.00. If they encounter only one strike with no-bid they will skip over that one and proceed to move lower. If they encounter two strikes in a row with no bids the formula will stop including strikes. They do the same for calls, starting at-the-money and moving higher until they reach two strikes in a row without bids.
That was probably already more than you wanted to know about VIX, but getting a good history about the beast will help us understand it in the future.
Simply the VIX tells us about implied volatility that is expected out of the overall market. Knowing this we must use our implied volatility rules.
Let's review them. Implied volatility is usually written as a plain number but is always expressed as a percentage. A VIX of 20 is actually a VIX of 20%.
This percentage move does not have a direction. A VIX of 20% describes a move that could be 20% higher or 20% lower. This percentage has been annualized for one standard deviation.
Example: The VIX is currently 20% while the S&P 500 is at 1,500. This means we are expecting a move to 1250 or 1800 by the end of the year, 68% of the time (one standard deviation).
Volatility is contrarian in nature. When the underlying moves higher, fear subsides, volatility decreases. When the underlying moves lower, fear increases, volatility increases.
To reduce volatility to an expected volatility we can use our volatility formula:
(IV / 16) x (SQRT(Number of days we want to use))
Using a VIX of 30% and to look out for 20 days we have:
(0.30 / 16 ) x (SQRT(20))
(0.01875) x (4.4721)
0.08385 or 8.385%
When Should We Be Scared
Unlike stock prices who can go up or down in a wide range the VIX is mean reverting. This means there is an average price for the VIX and if it gets too high above this average it will come back down, or if it gets too low from this average it will come back up.
The average price for the VIX is around 20%. Volatility moving back to the average is not an instant phenomenon. Trying to trade for the VIX to mean revert is a futile practice. Typically the VIX will not go too low, usually there is a floor around 10-11. What happens is that it can stay at this level or below the average for years at a time.
On the other hand there is not a ceiling and we will see the VIX quickly jump to 40-80%. When the VIX gets above the average it doesn't stay their for long. Typically you will not see the VIX stay at 40% for more than a couple of weeks if that long.
How To Trade The VIX
Trading the VIX is a complicated monkey and caution is urged before proceeding down this path.
An important side note about the VIX and technical analysis, don't do it. The VIX is a statistic derived for a formula. Technical analysis is tracking the movement and future predictions based on the actions of buyers and sellers. Resistance is formed by a surplus of sellers versus buyers and support is formed by a surplus of buyers versus sellers. When we deal with a formula we do not have buyers or sellers so save the technical analysis.
You cannot buy the VIX outright. Any trading of the VIX has to be done through options or futures. When we are dealing with options it is again not as straightforward as we are use to.
The VIX has a couple of components. There is the cash price which is the price that is typically quoted and the one we are use to seeing. There is also future prices which are broken into monthly expiration dates.
When we look the option chain for the VIX it looks like a normal chain that we would see on any stock. The trick with the VIX is that the option price expiration dates are correlated to the future expiration dates. When you trade an option you will not be trading it on the cash price. A lot of new traders do not understand where their prices are coming from when they trade VIX options.
Until you can get a clear understanding on how the VIX works and how the options are priced and move we would recommend holding off on trading the VIX.
Instead we would focus on using the VIX not as a trading vehicle but as an indicator.
Using The VIX As An Intraday Indicator
If you are a short term trader (day trader) you can use the VIX's intraday movements to get an idea of how the market will move.
As we have noted, volatility is contrarian in nature. When the market moves higher volatility will move lower, and when the market moves lower volatility will move higher. Our indicator will come from when we see a break in this negative correlation.
To get us setup to view this indicator we need to open our charts. We need one chart monitoring the VIX looking at one-day with five-minute bars. This means that the chart will show us all trading for one day, we don't need more than that, and each candle or bar on the chart will represent five minutes worth of time. Our second chart will be of the S&P 500 (SYM: SPX) with the same time frames, one-day with five-minute bars.
We are going to want to view these two charts at the same time because we are going to want to note when our correlations break. We don't need any indicators only price is necessary.
We want to view our charts when the market (SPX) is either at the highs of the day or the lows of the day. If the market is in between these two points our indicator doesn't perform well.
Once the market is at the highs for the day we want to look at our VIX. If the VIX is not at the lows for the day there is a high probability that the market will reverse and move lower. Typically when the VIX is not at the lows of the day, in this situation, traders are not believing the current move higher in the market and a reversal is near.
We can do the same thing when the market is at the lows for the day. If the market is at the lows but the VIX is not at the highs this is a good indication that a bottom may be in and the market will soon reverse. The probability of a reversal is higher in this scenario versus when the market is at the highs.
This intraday indicator only works in these two scenarios. You don't want to use it if the market is not at the lows but the VIX is at the highs of the day. This is a good sign that the market could continue moving lower.
Keeping an eye on this indicator can help you with your day trading. Now you can time the buying and selling of your positions with the movement of the market. It always helps to have the momentum of the market on your side when trading. If the market is going to bounce from the lows of the day you can believe that stocks will being to do the same.
Using The VIX As A Daily Indicator
In the same sense but not quite the same fashion we can use the VIX as a daily indicator like we did as an intraday indicator.
As you will see we will be again looking for correlation breaks. Whenever a strong correlation breaks that is the time we want to sit up and take notice.
To setup our charts to view this indicator we want a daily view of both the VIX and the SPX. The timeframe is really unimportant here and is usually up to personal preference. You really only need to see the last couple of days of trading. We like to set our charts to view six-months out but that is just personal preference. The candles or bars need to be set as one day so each candle is worth one day of time.
There are several ways to use this indicator and we will mention both here. The first one deals when the market is not in crash/correction mode. That is when we are not down 10% but maybe 2-3%. When the SPX moves +/- 1% you can expect the VIX to move 7-10% in the opposite direction. If volatility fails to make the expected move it could show that this run is not being believed by traders and it could come to an end.
For example if the S&P 500 moves down 1.5% for the day but the VIX has only rallied 4% we would expect this drop lower to be over soon. If we see this same action two days in a row we would expect a reversal the next day.
Sometimes there are other factors at play that keep the VIX's movement muted. For this reason we really like to see two days confirming this indicator.
The other way we like to use this indicator is when we are in a hard rally or sell off. When there doesn't seem to be an end in either direction and the VIX breaks its correlation to move in the same direction as the market we would expect an immediate reversal.
For example, if the S&P 500 is down 10% for the last two weeks and today it is down another 0.4% but the VIX is also down 2% we would expect then end of this sell off.
This is a pretty big break in correlation so we do not wait for two confirming days before we expect the reversal.
Understanding VIX Futures
VIX futures are a big area to tackle and would require several post not just the bottom section of one. Instead we are going to tackle two simple concepts: contango and backwardation.
Before we define these terms we need a good way to view the VIX cash and futures on one chart. Our go to resource is VIX Central who have developed a great tool for traders.
When dealing with the future, not just in trading, we are always more uncertain as our time frame goes further out. It is harder to predict what will happen in one month versus tomorrow or one year versus one month.
We see this in our option trading because we know that options are more expensive the further out in time we go, there is more uncertainty.
This is what we consider normal or when we talk about futures, contango.
When the VIX is in contango the further you go out in the future the higher the future price becomes, and all of them are higher than the cash price.
A VIX in contango would like this:
- Cash Price: 12.00
- Front Month Futures: 14.00
- Next Month Futures: 15.00
- 3rd Month Futures: 17.00
- 4th Month Futures: 20.00
- and so on...
This is normal and when things become very volatile the futures move into backwardation. Backwardation is when there price of the front month options is more expensive than the next month options.
When traders believe there is more volatility now than what they will see in a couple of months you know things are bad.
Here is an example of backwardation:
As you can see the cash price is the highest followed by the next month futures and then it slowly goes down from there.
The market does not stay in backwardation long as it will try to move back into contango. As long as the market is in backwardation there will be significant volatility in the markets.
While we just touched on the basics of the VIX you can already begin to see how useful it can be in your trader tool bag. For now we recommend focusing more on using it as an indicator of market movement versus a trading vehicle. Without a full understanding of VIX futures you could be setting your portfolio up for unnecessary losses if you try to trade it.
It doesn't matter if you are a day trader, swing trader or long term investor. The VIX can help time the market to set up your positions, portfolio or insurance plays.
How do you use the VIX with your trading? Let us know in the comments...