Traders have always sought to analyze the markets and predict further price movements. The methods and variants of such forecasts can be different. Some use charting patterns, others build complex indicator-based trading systems. But all these approaches have an alternative: the analysis of the VIX volatility index.
This instrument is an index of the future volatility of the American stock market. It is also called the “fear index”, because it is able to reflect the sentiment of market participants. When the value of the index begins to rise, this may indicate an increase in expectations of serious movements in the form of a correction or even the onset of the global financial crisis. This information, in turn, can already be used to make trading decisions.
In this article, we will talk about the VIX Index and try to figure out how to trade it and its derivatives.
What is VIX?
The Volatility Index (VIX) was created in 1993 by the Chicago Board Options Exchange. In a narrow sense, we can say that it reflects the opinion of traders and investors about the behavior of the stock market over the next 30 days.
The VIX is calculated using the Black-Scholes formula based on 8 stocks from the S&P 500. The VIX value can give an idea of how volatile future market movements will be, and this information, in turn, can help investors make the right trading decisions.
It is believed that with an increase in the value of the index, volatility in the markets will only grow. If the index is at a low level, then the market will remain stable, and expectations of a surge in volatility and possible disruptions in the global economy will be in vain.
For example, in March 2020, the index values climbed high, reaching the level of 2008, when the entire world was going through an incredible economic crisis. Indeed, the beginning of 2020 turned out to be very unstable on stock exchanges and greatly frightened investors, which ultimately resulted in a large drop in stocks.
It is now clear that when the market decline only deepens, panic and uncertainty among investors also grows, and the VIX values rise. Using the VIX, you can try to recognize both the beginning of a panic and its potential end and slowly acquire securities that have lost in value.
How do I use the VIX index?
It is believed that it was the financial crisis of the banking sector that strongly piqued the interest of traders to make money on volatility. To meet this demand, products have emerged that have made it possible to invest in the VIX through ETFs and ETFs.
On the one hand, such investments can make it possible to profit from the movement of the VIX index or provide an opportunity to hedge risks from a likely fall in the stock market. As a result, the growth of expectations of increased volatility in the markets and the purchase of the VIX index or its derivatives will be able to compensate for the drawdown in the portfolio when the market really goes into a protracted correction.
By opening a position in the VIX index, you can cover other transactions on stocks in the portfolio and insure your position in the market. For example, if a trader has bought stocks that are part of the S&P 500 and he wants to smooth out the possible consequences of an increase in short-term volatility, he can open a VIX buy deal to reduce the risks from a correction in stocks. If the trader is mistaken and the increase in volatility did not occur, the profit from the purchase of shares compensates for the loss on a long position in the VIX index.
How do I trade the VIX?
Most often, the fear index is invested through Exchange Traded Funds (ETFs) and Exchange Traded Notes (ETNs). Let’s take a closer look at some of these tools.
ProShares VIX Short-Term Futures ETF (VIXY)
ProShares VIX Short-Term Futures ETF (VIXY) is a fairly popular instrument among ETFs. This fund reflects the volatility dynamics of the VIX index based on the S&P 500 VIX Short-Term Futures Index, which, in turn, consists of a set of short-term VIX futures.
However, VIXY is only recommended for experienced investors who understand what they are doing. Typically, such an investor either seeks to profit from the increase in volatility in the S&P 500 index, or hedges from a strong fall in the stock market.
iPath B S&P 500 VIX Short-Term Futures ETN (VXX)
Among ETNs, the iPath B S&P 500 VIX Short-Term Futures ETN (VXX) instrument is popular. It offers access to the daily moving long position in the first and second month VIX futures contracts. VXX reflects investor expectations about the future direction of the VIX at the expiration of the futures contracts that make up the index.
The asset is volatile and movements can reach up to 10% per day, however, where there are high risks, there are potential profits that may interest aggressive traders. It is worth noting that the VIX movements may not coincide with the VXX fluctuations, there is some lag.
Traders also note the fact that VXX is not suitable for long-term positions, but the negative correlation with the S&P 500 index remains here. Therefore, a trader at the time of a strong correction of the entire stock market has the opportunity to capitalize on the growth of volatility by using the iPath B S&P 500 VIX Short-Term Futures ETN (VXX).
The VIX index, in fact, reflects the volatility of the American stock market. If the index values have risen high, then there is a fear among investors about the upcoming correction in the stock market. If the VIX values are low, it indicates the calmness of investors and confidence in the future rise of the stock market.
It is worth noting that investing in VIX is considered risky. They should only be considered by short-term aggressive investors. Unfortunately, the “buy and hold” principle will not work here, you will have to regularly monitor transactions and the behavior of the entire market in order to prevent serious losses.
The best time to invest in “volatility” is the onset of the financial crisis, because in a panic, market participants will begin to sell off their assets, which will provoke an increase in volatility, as well as a rise in the VIX index.
Don’t forget about derivatives such as ETFs and ETNs associated with the VIX: they are readily available and can be bought and sold just like any other stock on the market.