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Fear Index I What is the VIX and how do you trade it?

Fear Index I What is the VIX and how do you trade it?

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

Traders should keep a close eye on the CBOE Volatility Index, also known as the ‘terror index' or VIX index when trading major indices like the S&P 500. The S&P 500 - VIX correlation is a primary example of why the relationship between the U.S. stock market and the VIX index is referred to as a “fear barometer”.

There is quite a bit you should know before you dive in. If you want to trade the VIX index right away, here is a quick guide:

  • Decide how to trade forex VIX - The most popular include speculating on the futures price movements through CFDs.
  • Decide where to go long or short – With CAPEX.com volatility traders are not interested in whether the price of the S&P 500 is going to rise or fall, as they can capitalize on both.
  • Take your positionCreate an account with us to start VIXX CFD trading.

For more info about how to trade the VIX index, you can discover everything you need to know in this comprehensive guide.

What is the VIX (Fear Index)?

The Cboe Volatility Index (VIX) is a real-time index that represents the market's expectations for the relative strength of near-term price changes of the S&P 500 index (SPX). Because it is derived from the prices of SPX index options with near-term expiration dates, it generates a 30-day forward projection of volatility. Volatility, or how fast prices change, is often seen as a way to gauge market sentiment, and in particular the degree of fear among market participants.

The index is more commonly known by its ticker symbol and is often referred to simply as "the VIX." It was created by the Chicago Board Options Exchange (CBOE) and is maintained by Cboe Global Markets. It is an important index in the world of trading and investment because it provides a quantifiable measure of market risk and investors' sentiments.

It’s a real-time index which reflects market participants’ expectations of volatility over the next 30 days.

Source: CAPEX Webtrader

At the most basic level, the VIX index is constructed using weekly and traditional SPX index options and their levels of implied volatility. One can think of implied volatility as expected volatility derived from market participants’ activity in the options market. Understanding why the VIX behaves inversely to the S&P 500 is important because the volatility index acts as a measure of market sentiment, hence the reason it is called a “fear barometer” or “terror index”.

Why trade the VIX?

VIX-linked instruments have a strong negative correlation with the stock market, which has made them a popular choice among traders and investors for diversification and hedging, as well as pure speculation.

By taking a position on the VIX, you could potentially balance out other stock positions in your portfolio and hedge your market exposure.

Let’s say that you have a long position on the stock of a US company that was a constituent of the S&P 500. Although you believe it has long-term prospects, you want to reduce your exposure to some short-term volatility. You decide to open a position to buy the VIX with the expectation that volatility is going to increase. By doing so, you might balance out these positions.

If you were wrong, and volatility didn’t increase, your losses to your VIX position could be mitigated by gains to your existing trade.

How to trade the VIX

Research how the VIX index works

The VIX works by tracking the underlying price of S&P 500 options – not the stock market itself.

What is the relationship between VIX Index and S&P 500?

The S&P 500 VIX has a propensity to rise in bearish stock market environments and fall or remain steady during bullish environments. This happens because of the long-term bullish bias of the stock market and the fact that the VIX index is calculated using implied volatility.

Implied volatility goes up when there is strong demand for options, and this typically happens during declines in the price of the S&P 500 as market participants (who are collectively bullish) are quick to buy protection (put options) for their portfolios.

When the S&P 500 rallies we see demand for protection dissipate and as a result a decline in the VIX. This process in recent years has become exasperated, in all likelihood, because the VIX has gone from just a market gauge of volatility to a tradable asset class through product offerings on various futures, equities, and options exchanges.

Source: TradingView

Dating back to the beginning of the VIX in 1990, the correlation between daily changes in the S&P 500 and VIX is -77%. Over the past 10 years, the inverse correlation has become even stronger at -81%, while prior to October 2010 it was -74%.

Understanding VIX values

There is a strong negative correlation between the VIX and stock market returns. If the VIX moves up, it is likely that the S&P 500 is falling in price due to increasing investor fears. If the volatility index declines, then the S&P 500 is likely to be experiencing stability and investors are relatively stress-free. Trading volatility is not the equivalent of a market downturn, as it is possible for the market to decline but volatility remains low.

Volatility is a measure of the movement of an asset’s price, rather than the price of the asset itself. This means that when you trade volatility, you aren’t focused on the direction of change, but on how much the market has moved and how frequently movement occurs. This is why VIX values are quoted as percentage points.

As a rule of thumb, VIX values greater than 30 are generally linked to large volatility resulting from increased uncertainty, risk, and investors’ fear. VIX values below 20 generally correspond to stable, stress-free periods in the markets.

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.

Using a VIX stock chart to predict market volatility

The S&P500 VIX can be used to identify market turns, more specifically bottoms. Because the stock market tends to rise in a gradual fashion the VIX too will decline in a gradual to sideways fashion. This can lead to very low levels which warn of complacency as investors feel no need for protection, but these periods can last long enough that using the VIX as a sell signal can be rendered largely ineffective.

However, because the S&P 500 is long-biased by nature when there are declines investors buy protection (put options) quickly, driving up the VIX. Often there is an overreaction by market participants when the market declines, hence the reason why the VIX is called a “fear index”.

The spike-like behavior which the VIX exhibits during times of market stress can be a timely signal for determining when selling has become overdone and the market is due to bounce or even bottom for a longer-term move higher. This strategy is typically best employed when the VIX ‘signal’ arrives within the context of a general bullish trend in the S&P 500.

VIX live chart price spikes can be used to indicate stock market bottoms.

When the VIX live chart price is at very low levels, there is a nuance to this which can help identify when the stock market may be nearing a turning point to the downside, but they don’t happen frequently. When the VIX and S&P 500 both rise together over a period of time it can indicate growing instability in the trend which sets the market up for a sell-off.

Decide where to go long or short on the VIX index

Like all indexes, the VIX index is not something you can buy directly. Moreover, unlike a stock index such as the S&P 500, you can't even buy a basket of underlying components to mimic the VIX. Instead, VIX trading is possible only through futures contracts and through exchange-traded funds (ETFs) that own those futures contracts.

>> Learn more about Futures Trading

With us you can trade VIX through CFDs. CFD trading is defined as ‘the buying and selling of CFDs’, with ‘CFD’ meaning ‘contract for difference’. CFDs are a derivative product because they enable you to speculate on financial markets such as shares, forex, indices and commodities without having to take ownership of the underlying assets.

Instead, when you trade a CFD, you are agreeing to exchange the difference in the price of an asset from the point at which the contract is opened to when it is closed. One of the main benefits of CFD trading is that you can speculate on price movements in either direction, with the profit or loss you make depending on the extent to which your forecast is correct.

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 capitalize on both – they are instead looking at whether the market is volatile.

VIX Fear Index - SP 500

Going long on the VIX

The position you decide to take will depend on your expectation of volatility levels. 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.

For example, if you thought that the S&P 500 was going to experience a significant and rapid decline following a political announcement, you might take a long view of volatility. You could do this by opening a position to buy the VIX.

If there was volatility, your prediction would have been correct, and you could make a profit. However, if you had taken a long position and there was no volatility in the market, your position would have suffered a loss.

Going short on the VIX

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.

Let’s say that the combination of low volatility and high economic growth had led to steady growth in the S&P 500 constituent’s share prices. You might decide to short volatility with the expectation that the stock market will keep rising and volatility will remain low.

If the S&P 500 does rise, then the VIX is likely to move to a lower level, and you could make a profit. However, shorting volatility is inherently risky, as there is the potential for unlimited loss if volatility spikes.

How to Trade the VIX Index with CAPEX.com

Follow the steps below to start VIXX CFD trading with CAPEX.com:

  • Create a CAPEX.com account
  • Open the VIX chart
  • Go either ‘long’ (if you think the price will rise) or ‘short’ (if you think the price will fall)
  • Trade CFDs on VIX futures with zero commission, tight spreads, and fast order execution
  • Take steps to manage your risk (position size, stop loss, take profit)
  • Monitor and close your position
VIXX trading CAPEX.com
Source: CAPEX Webtrader

VIX ‘Fear Index’ summarized

To summarize, understanding stock market volatility and the’ Fear Index’ (VIX) is important for trading stocks. There are benefits to understanding the nature of volatility from both an analytical and risk management standpoint. Like all things, getting a feel for the relationship between the VIX fear index and the S&P 500 will take a little experience to get a handle on, but well worth the time.

  • 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.
  • When the VIX goes up in value, it means the price of the S&P 500 is likely falling and the value of SPX put options is increasing.
  • 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.
  • You can use the VIX as part of a trading strategy as it can give indications of whether the S&P 500, and the stock market in general, is going to reverse from its current trend.
  • The key thing to remember is just that the VIX index 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 fear index a popular hedging tool.

FAQs

What Does the Cboe Volatility Index (VIX) Signal?

The Chicago Board Exchange Volatility Index (VIX) signals the level of fear or stress in the stock market—using the S&P 500 index as a proxy for the broad market—and hence is widely known as the “Fear Index.” The higher the VIX, the greater the level of fear and uncertainty in the market, with levels above 30 indicating tremendous uncertainty.

How Can an Investor Trade the VIX?

Like all indices, the VIX cannot be bought directly. However, the VIX can be traded through futures contracts and exchange-traded funds (ETFs) and exchange-traded notes (ETNs) that own these futures contracts.

Does the level of the VIX affect option premiums and prices?

Yes, it does. Volatility is one of the primary factors that affect stock and index options’ prices and premiums. As the VIX is the most widely watched measure of broad market volatility, it has a substantial impact on option prices or premiums. A higher VIX means higher prices for options (i.e., more expensive option premiums) while a lower VIX means lower option prices or cheaper premiums.

How can I use the VIX level to hedge downside risk?

Downside risk can be adequately hedged by buying put options, the price of which depends on market volatility. Astute investors tend to buy options when the VIX is relatively low and put premiums are cheap. Such protective puts will generally get expensive when the market is sliding; therefore, like insurance, it’s best to buy them when the need for such protection is not obvious (i.e., when investors perceive the risk of market downside to be low).

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