What is the VIX? It’s also known as The Fear Index. With so many indicators out there, would this be one to add? Trading the stock market is fun to think about. When times are tough, knowing how to trade can be extremely beneficial. As a result, many people jump on the trading bandwagon.
Many think they’re going to get rich quickly. But it doesn’t turn out that way. So what if there’s a way to help measure volatility? The VIX is perhaps one of the best gauges of market deep-rooted concern and one of the most closely watched measures of market volatility.
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VIX CBOE Volatility Index Introduction
The Volatility Index (VIX) measures differences between prices on future calls and puts. If call options are being purchased for dates several months in the future for wildly varying prices, the VIX should have a high number, typically in the twenties or thirties. If calls are trading at similar prices (not necessarily the same as the current stock prices), the VIX should have a low number in the single digits or teens. Interestingly, the market seems to react to the same information the VIX reacts to, in that days when the market swings seem to correlate to days when the VIX is high.
This article attempts to answer three major questions about the VIX index. First, how reliable is the VIX? Specifically, can an index that measures unpredictability reliably measure it? Is there a difference between predictably unpredictable, unpredictable, and very unpredictable?
Second, how useful is the VIX? Specifically, does a change in the VIX index provide enough information to take action in the market? Or are changes in the VIX priced immediately?
Finally, how would one use the VIX index to adjust strategy in day trading? If the VIX is reliable and useful, does it have applications to patterns?
What Is Volatility?
Put simply, volatility is a statistical measure of the degree of variation in the trading price of a security (e.g., a stock) over a specific period.
Likewise, the more dramatic the price swings in that instrument, the higher the level of volatility, and vice versa. Although volatility can keep even the calmest investors up at night, it can also be a day trader’s dream. As you know, day traders—scalpers especially—thrive on short-term price swings. A 1000 shares at $0.20 profit here and there adds.
But these swings aren’t going to happen unless there’s a trigger—like mass panic due to a virus. Without swings, there’s no money to be made.
VIX CBOE Volatility Reliability
What does reliability mean? Naively, if the VIX index is low, one would expect the volatility in the market to be low for several months in the future.
If the index is higher, limited future volatility would be expected. And if the index is very high, extreme volatility would be expected.
Since it’s measuring future chaos, one would want it to be reliable. However, it is not overly reliable since chaos is inherently unpredictable.
To test reliability, we look at three ranges of values for the VIX:1. 0 < VIX < 152. 15 <= VIX < 193. VIX >= 19
We hypothesize that average market volatility in the six months succeeding a VIX measurement will be very limited for case 1, limited in case 2, and unlimited in case 3.
If not rejected, the hypothesis will supply specific volatility measurements that we may be able to use in trading.
Background on the VIX
The brainchild of the Chicago Board Options Exchange (CBOE), the VIX is a real-time market index representing the market’s expected volatility in the coming 30 days.
Using price inputs of the S&P 500 index options provides us with a measure of market risk and investor sentiment.
You might also have heard it referred to as the “Fear Gauge” or “Fear Index.” It’s considered to be the leading indicator of the U.S. stock market.
The Fear Index is explained in our live trading room. We use it in tandem with our stock selections.
What Does a Low VIX Mean?
When the VIX is low, SPX options are cheap because traders expect very little volatility in the next 30 days.
And since stocks tend to fall a lot faster than they rise, it can be assumed that when traders expect low volatility, they expect stock prices to rise.
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What Does a High VIX Mean?
When the VIX is high, options traders expect a lot of volatility, which leads to falling stock prices. This translates into people paying a higher-than-normalmium to protect themselves against a downward stock move.
So, it accurately measures the fear expressed by options market participants at that moment.
The index can be used in contrarian investing, according to the adage “buy when there’s blood on the streets “… as long as you’re sure there’s not going to be more blood on the streets tomorrow, of course.
As the saying goes, buy the dip, but don’t try to catch a falling knife. Otherwise, your blood will be on the streets.
Easiest Way to Measure Reliability
The easiest and most standard way to measure reliability is by measuring combined returns. We took the ending monthly values of the VIX from January 1990 through September 2019; since we’re looking at several months of future activity, daily swings in the VIX would not matter.
Then, the combined monthly returns of the S&P 500 for the same period are taken. We created a data set comparing returns to volatility in six-month periods, looking out six months from each month to select and normalize combined returns of the S&P to each VIX category, generating several thousand data points.
We hypothesized that the VIX category would not predict combined returns.
Regressing normalized combined returns against VIX categories revealed that the coefficients of the categories were significant, with a confidence level of 95% or higher.
Thus, we could reject the hypothesis and proceed under the assumption that VIX values above 19 correlate with different combined returns than VIX values between 15 and 19 (VIX values below 15 were assumed to have little to no market volatility and were ignored).
What Is the VIX Usefulness?
The hypothesis test has also answered the question of usefulness. While volatility predicted by the VIX is probably priced immediately by the market, the fact that the hypothesis was rejected indicates that not all the volatility is priced immediately.
Therefore, opportunities to profit exist for several months after a change in the VIX. You can also use the TTM Squeeze to make quick trading decisions.
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Is the VIX a Leading Indicator?
When it comes to indicators, we get leading or lagging. When an indicator is lagging, it reads past data. The VIX would be a leading indicator because it’s economic data used to predict and forecast future events.
Applicability
A pattern screener uses several parameters to decide if a pattern is present (or likely to be present) in stock prices. For example, an ascending or descending channel is defined by the distance between the trend lines, the number of breakouts, the entrance criteria to the pattern (when prices begin to move within the trend lines), and the exit criteria (when have prices diverged far enough from the trend lines to be called an exit).
If you were to look at several months of stock prices and apply a particular pattern screener, you would identify several instances of the pattern in the data.
If you take the very same data and adjust the prices to reflect an increase in volatility while still maintaining the general trends of the data, the screener ought to find fewer instances of the pattern because:
- More breakouts will appear to exit because breakouts will occur more often, move further above or below the trend lines, and fail to match the screener’s breakout parameters.
- The trend lines will be further apart, failing to match the screener’s parameters.
- The entry points may not be identifiable to the screener since the trend lines are further apart.
- The exit points may be prematurely identified (really breakouts).
Thus, if the VIX were to increase today, the number of patterns identified by screeners would be reduced, and with the same number of traders trading the stocks, these patterns would be overtraded and less profitable.
The obvious suggestion is to react to a change in the VIX by modifying your screener parameters to pick up the patterns that would not be found and trade those patterns.
Parameters
For example, suppose the VIX goes up a given percent, and you start a new screener, adjusting the parameters accordingly. You then run the old and new screener in parallel.
Any pattern found by the new screener, not the old, will likely be thinly traded and more profitable.
Given a particular change in the VIX, how would you adjust the parameters? Since pattern trading is stock-specific, changes in the VIX will be manifested differently in individual stock prices. We recommend the following approach:
First, select stocks of interest to you. Then, grab several months of price data and calculate Excel’s monthly (or daily or weekly) standard deviation. In a second column, get several months of VIX values (actual value or change in value) and compare the volatility of your stock to the VIX.
The result you want to calculate is: for any given value or change of value in the VIX, a likely standard deviation in price changes in your stock. It doesn’t have to be scientific. A blue-chip stock will have fewer price swings than a small-cap stock, and you merely want to understand how much your stock price moves instead of the overall market.
Then, select a period in the past, look at the VIX, select a period in the future, and decide what the likely volatility of your stock will be.
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Trading the VIX
Like all indexes, one cannot buy the VIX directly. However, we know that money is to be made in volatile markets. CBOE realized that they could make money if they could capture volatility and package it into a tradable product.
And deliver it they did. In 2004, the first VIX-based exchange-traded futures contract was created. Shortly after that, VIX options were launched, paving the way for users to utilize volatility as a tradable asset.
Many active traders, large institutional investors, and hedge fund managers use VIX-linked securities for portfolio diversification. History demonstrates a strong negative correlation between volatility and stock market returns. In other words, when stock returns go down, volatility rises, and vice versa.
Are you interested in getting into the game? Why don’t you check out ProShares VIX Short-Term Futures ETF (VIXY) or iPath Series B S&P 500 VIX Short-Term Futures ETN (VXXB)?
VIX CBOE Volatility Example
For example, suppose my stock symbol is ABC, and its average daily standard deviation is 9%. But I’ve decided, based on the recent values of the VIX, that the likely standard deviation shortly may be closer to 18%.
This is the same as predicting that breakouts will be twice as big (18% divided by 9% = 2) and trend lines will be further apart by 9% (18% – 9% = 9%). Exits will naturally need to be larger than breakouts.
If I take my standard screener for, say, an ascending or descending channel, create a new screener with the new parameters, and run both in parallel, choosing only the patterns found by the new screener, it’s likely that
a) such patterns will exist (you did the calculations, after all), and) fewer traders will trade the new patterns,
Leaving you with less competition at those particular points in time for trading the stock.
Key Takeaways
- The CBOE Volatility Index, or VIX, is a real-time market index representing the market’s expectations for volatility in the next 30 days.
- We use the VIX to measure the market’s risk, fear, or stress level to make investment decisions.
- Day and swing traders can also trade the VIX using various instruments, such as options and exchange-traded products.
- A high VIX indicates pessimism by option traders.
- The more panic in the market, the bigger the VIX spike. So, if the market suddenly drops in an hour, the VIX likely will spike.
Final Thoughts: What Is the VIX?
When the VIX rises, stock prices decline because traders and investors use it to hedge their equity positions. As the VIX continues to soar, economic uncertainty continues. But we know uncertainty brings volatility, and volatility means money is to be made. Regarding where the VIX will go, it’s anyone’s guess.
The VIX is a great leading indicator for volatility with options. Options are also a great way to grow a small account. You’ll be much better when you learn how to use the VIX in your trading.
Frequently Asked Questions
Most, if not all, traders have heard of the VIX. But did you know it was called the fear index? Volatility moves markets. And fear causes that volatility. It can be detrimental if you don’t know when volatility will hit. As a result, having a fear index and knowing how to read it is extremely helpful.
The fear index is also known as the VIX. So what does that mean? The VIX is also known as the volatility index. Since traders thrive on volatility, this is a way to measure it in stock market trading.
