*Taking a look at volatility in the equity markets and trading the VIX*
Welcome back to the blog and happy Friday! In this blog post I am going to talk about Volatility (Vol) in the equity markets and look at the current levels of Vol in markets you may or may not be trading right now. I will finish with my own analysis of the current intraday chart of the VIX and where I think some trading opportunities might arise. Let’s get right to it.
Volatility is a statistical measure of the dispersion of returns for a given asset or security. It is normally assumed that the higher the volatility levels are, the riskier the asset is. Volatility is present in every market. If price fluctuates, there is a measure of volatility.
The diagram above shows two basic bell curves which are created using the standard deviation of price of a stock. Volatile stocks have much larger tails vs a less volatile stock and that means there is a greater tail risk. You may have heard this term used before but essentially, tail risk is not good for investments because there is a greater probability that price will move more than 3 standard deviations away from its normal distribution. There chance of your investment seeing abnormal sized losses is much greater.
If you are interested in learning more about this then please read through my Trading Market Volatility series of blog posts.
Current volatility in Equity markets.
Although we are at levels less than 30% of that when the coronavirus pandemic was at its peak, Volatility is still higher than average across the equity markets. Let’s take a look the VXEFA which measures the expected volatility of the iShares MSCI EAFE Index Fund (EFA), an exchange traded product (ETP) that offers exposure to developed-market stocks in Europe, Australia, Asia and the Far East. It is therefore a relatively good measure of equities from developed markets globally.
As you can see on the chart above, from the highs of this year back in March, the VXEFA has dropped by more than 75% in value. This looks like a large correction and if one to were simple look at the last 6 months of price action, it would be safe to assume that global stock market volatility is low right now.
However, even at current levels (circa 25.00) the VXEFA is still more than 150% higher that it was at it’s lowest last year! The VXEFA is also still trading above the 50EMA on all timeframes from the weekly down to the 1 hour.
Let’s take a look at the VXN (Cboe NASDAQ-100 Volatility Index) and it’s corresponding Index which is the NASDAQ 100. This is an extremely tech heavy US stock market index and therefore it has seen a miraculous recovery since the “crash” back in March this year.
As you can see, the NASDAQ100 index (in red) was down almost 40% at it’s lows this year where it has since recovered and made new all time highs and is now trading around 22.52% higher for the year to date. One would normally assume that the VXN should be trading around historic lows right now because the correlating stock market is at all time highs.
Historically, the VIX index and the correlating stock market have an inverse relationship. That is that when stock markets are rising, the VIX falls and vice versa however there is nothing normal about the year 2020 as we know.
Instead, the VXN is still trading at levels more than 135% of that at the start of the year before the coronavirus pandemic arrived in the western world. This is huge and clearly a sign that markets are still volatile despite rising stock market prices. This also proposes a dilemma for the future if US stocks do begin to fall once more like they did earlier in the year because Volatility is already high, there is a strong chance that it will therefore head to levels never before seen.
From the start of the year to the height of the pandemic, the VXN gained almost 400% in value or almost 68 points. Assuming the NASDAQ100 is efficiently priced and correct in trading at near all time highs and positive for the year, then we can assume that volatility is correct at it’s current level. Therefore, if stocks in the NASDAQ100 index were to once again sell-off like they did earlier in the year, Volatility is set to climb at the same rate. I have shown this on the chart above.
That could potentially see the VXN increase above the 100.00 price level. At its highest during the 2008 financial crisis, the VXN traded at 86.52 and in 2001, when the DotCom bubble burst, the VXN was still only trading at around 99.00 at it’s highest.
There is a very good chance that stock market volatility, including the VXN and possibly others, could go on to trade at new all time highs in the near future. Levels never before seen and this will effect every part of the financial markets system from options prices through to the largest pension funds and institutions.
Trading the VIX.
The VIX is the ticker for the CBOE Volatility Index. This is the oldest and most widely used instrument for trading Implied Volatility in the stock markets. “The VIX Index is a calculation designed to produce a measure of constant, 30-day expected volatility of the U.S. stock market, derived from real-time, mid-quote prices of S&P 500® Index (SPXSM) call and put options. On a global basis, it is one of the most recognized measures of volatility — widely reported by financial media and closely followed by a variety of market participants as a daily market indicator.” – http://www.cboe.com/vix
Let’s look at the current intraday chart and I will show you why I think there are potential trading opportunities available right now.
I believe we are heading towards another push to the upside on VIX. The technicals are lining up for buyers with lots of small points of analysis giving me confidence that buying at these levels could prove profitable through the next few weeks.
Since the large spike up to the 85.00 back in March when the coronavirus pandemic was at it’s peak, VIX has continued to slowly fall whilst painting a wedge consolidation pattern. This was subsequently broken to the upside last month and I think we are now in a slow bullish trending phase where price is starting to print higher values. The 22.00 support zone has held strong and the 50 and 200 EMA’s are aligned in a bullish fashion with price riding above both EMA’s. I have drawn a simple trendline across the higher lows that are forming and I think that this trend could contine over the next few weeks.
Upside targets for me are the near term resistance zone at 36.00 and if that was to break then 42.00 is the next price target. This all depends on buyer sentiment and global risk attitude because as we know, the VIX is price from implied volatility of the S&P500 index and they tend to have a negative correlation. If there is another large reduction in global risk sentiment then I can see no reason why VIX wont spike up to 36.00 or 42.00 or higher.
There has been a well known saying in finance that is “shorting Volatility is like picking up pennies in front of a steam roller”. This implies that shorting Vol may work in the short term but long term volatility will always increase at some point and you will lose.
Looking at the chart above it is quite clear to see why this saying withstands the test of time. As explained earlier, there will always be “some” volatility in stock markets or any market in reality. So long as price is moving and there are buyers and sellers, there will be volatility. This is proven by the clear and evident floor for Vol on the chart above which sits around the 10.00 level.
Buying VIX at these lows as always proved profitable in the long term with Vol increasing consistently throughout the year and larger spikes coinciding with higher impact events such as the drop in global equities in 2018 and the US presidential election in 2016. It is still profitable to short Vol but I would advise anyone doing so with a long term view or bias.
If you are a regular reader of my blog you will know about my Trading Market Volatility series of blog posts. These explained the VIX, volatility and trading volatility in more detail and I even showed a few of my own short duration VIX day trades. If you haven’t read these blog posts then you can find them via the links below.
If you are interested in learning my personal trading strategies, please consider my Mastering The Markets – Retail Trading Course. Head over to my Trading Education page to check out all of my education packages and the deals available.
All my technical analysis is done using the TradingView platform. You can get access via the link below.
My preferred broker of choice is IC Markets. Low spreads and trading costs really help long term profitability. A link to their site is below.
FTMO Trader Funding Programme.
Thanks for reading and please don’t forget to LIKE, SHARE and FOLLOW my blog to stay up to date with the latest market analysis and trading education posts.
DISCLAIMER: None of the information posted on this site is to be considered investment/financial advice. Trading is high risk and you should only trade with money you can afford to lose.