The CBOE (Chicago Board Options Exchange) Volatility Index (Ticker: VIX) is potentially the most popular volatility index in the world. It’s derivatives allows traders to make bets on the future increases/decrease in market volatility.
The Volatility Index (VIX) cannot be traded via the Index directly, instead Exchange Traded Funds (ETF’s) linked to VIX, futures and options contracts must be used. They all serve a different purpose depending on what you are trying to a achieve by trading the VIX and your directional bias for the future.
I will talk more about how I plan to trade VIX in the future later on in this blog post.
VIX and the stock market.
The stock market, S&P500 index, generally moves inversely to the VIX volatility index. This is seen most easily over the longer timeframe with the largest spikes in volatility occurring when the stock markets sell-off.
The daily timeframe chart below shows this occurring with the VIX (blue) and the S&P500 (red).
The VIX is a measure of implied stock market volatility in the future. The reason why it moves inversely with the stock market is because it does not matter which direction traders believe the stock market will move in the future, by purchasing VIX futures or call options they are betting that the stock market will move and move big.
When markets begin to sell off you will see the VIX index begin to rise where it is then suppose to reach its “peak” when the stock market reaches its “bottom”.
How do traders use the VIX?
One of the biggest uses for VIX is to hedge stock based portfolios. If you are managing a portfolio that is highly correlated to US stocks and more importantly, the S&P500 then it is possible to use the volatility index to protect against a future stock market crash.
By purchasing near-term call options to futures contracts on the VIX, if the worst was to happen and the stock market crashed then it is highly likely that the VIX will spike in price high enough for the value of the call options to offset any potential losses in the stock market based portfolio.
The chart above shows how a very small VIX hedge of 10% of the total portfolio managed to reduce the losses incurred on a purely S&P500 based portfolio during the 2008 crash.
This is a very basic example of this scenario. To hedge a stock based portfolio using the VIX index you must successfully calculate how many VIX call options to purchase based on the size and value of your stock market portfolio. You must also closely monitor the trading costs of buying the call options because if the stock market does not crash, you will likely lose potential profit on those option you have pruchased.
Short term trading with VIX.
Short term trading the VIX can be done much like short term trading on any other Index or financial instrument. Technical and fundamental analysis can give you an insight in to how stock market volatility might move in the near future.
One method of anticipating and trading short term increases on the VIX is to look at the S&P500 futures chart on a low timeframe (15 minute) or intraday timeframe and look for potential price breakouts. If you see price pausing and consolidation forming on the stock market, this can be a good sign that a potential breakout and momentum move is about to occur. The impending breakout momentum, if strong enough, will then cause the stock market volatility index (VIX) to increase in the near term.
Look for consolidation patterns like the bullish or bearish flag pattern or wedge pattern. Another good indicator for predicting a strong momentum move is to use Bollinger bands and wait for them to squeeze price together. The Bollinger band squeeze is a well known technical trading strategy used by financial market traders.
How I plan to trade VIX.
My VIX trading strategy that I am currently working on revolves around trading VIX futures. It is a short term trading strategy that profits on the decrease in implied stock market volatility around high impact news events.
The main premise behind this trading strategy is that short-term implied volatility actually decreases after high impact economic news is released because a level of uncertainty has been removed from the markets now the actual results of the data have been confirmed. This is similar to the age-old quote:
“Better the devil you know than the devil you don’t”.
In the lead up to key data releases, the VIX will get its values from the volatility expected by traders for the next 30 days. If a high impact data release is expected then VIX will be trading higher because there are levels of uncertainty implied from the, as yet, unknown data figures.
I have found that for the majority of a certain high impact data release, it is possible to profit from the change in levels of expected uncertainty as displayed by the VIX. Once the high impact data is actually released to the markets, the levels of short-term implied volatility is reduced because the unknown data is now known and the financial markets can deal with it. It does not matter whether the figures are positive or negative for the economy or whether they are better or worse than expected. When the data is released, traders, investors, business owners and governments can deal with the figures and uncertainty is reduced because the markets move in a single direction based on the figures released.
The levels of volatility displayed on the VIX are caused by market participants not knowing which way the financial markets might move. This is the uncertainty which is then removed when a prevailing market directional bias is found when the data is released. Therefore, reducing volatility.
The main benefit for trading the VIX instead of the US Dollar or stocks or fixed income instruments is that instead of trying to predict the upcoming data figures, you can trade the almost guaranteed outcome that implied volatility will be reduced in the short term. Your potential returns are then governed by how much the VIX drops after the data is released.
Trading Market Volatility Part 3 – coming soon.
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