One of the most widely used indicators of market emotion is the volatility index or VIX. The VIX provides traders with not just a helpful tool for measuring risk, but also the opportunity to profit from volatility. Learn how to trade the VIX, including how to short the VIX and instances of volatility trading.
What exactly is the VIX?
A real-time volatility index, the VIX, was developed by the Chicago Board of Trade Options Exchange (CBOE). It was the first benchmark to assess the expectations of the market about volatility. Although the index is forward-looking, it only indicates the implied volatility of the S&P500 (SPX) for the next 30 days, which is a limitation of the index.
The VIX is derived using the pricing of SPX index options and is represented as a percentage of the index’s closing price (the strike price). In general, if the VIX value grows, it indicates that the S&P500 is dropping, and if the VIX value decreases, it indicates that the S&P500 is stable.
Despite the fact that the VIX solely gauges volatility in the S&P500, it is widely regarded as a benchmark for the whole US stock market. Due to the fact that traders and investors like to buy options when anything is concerning the market, their prices rise when the market is concerned, making them an excellent indicator of volatility. In fact, because it monitors the degree of worry and tension in the stock market, the VIX is often referred to as the “fear index.”
Because the current level of volatility cannot be predicted in advance, the VIX should be utilized in conjunction with a historical analysis of support and resistance lines. When anything worries the market, traders and investors tend to start buying options, causing prices to climb. This is why options are considered a decent barometer of volatility. In fact, because it monitors the degree of worry and tension in the stock market, the VIX is often referred to as the “fear index.”
Because the current level of volatility cannot be predicted in advance, the VIX should be utilized in conjunction with a historical analysis of support and resistance lines.
What is the purpose of trading the VIX?
As a result of their substantial negative correlation with the stock market, VIX-linked products have become a popular choice among traders and investors looking for diversification and hedging opportunities, as well as for pure speculation.
By holding a position in the VIX, you have the opportunity to balance out other stock investments in your portfolio while also hedging your exposure to the stock market.
Consider the following scenario: you hold a long position in the shares of a United States firm that was a component of the S&P500. However, despite the fact that you feel it has long-term potential, you want to minimize your exposure to any short-term volatility. You make the decision to initiate a trade to purchase the VIX index, with the assumption that volatility would grow. You might be able to bring these opposing viewpoints into harmony in this way.
The risk of being incorrect is that if volatility does not grow, the losses on your VIX position may be offset by gains on your current trade.
Investigate how the VIX index operates.
The VIX index, rather than the stock market itself, is calculated by tracking the underlying price of S&P 500 options. You’ll learn about S&P 500 options, how the VIX index is generated, and what its value signifies in this section.
Options on the VIX and the S&P 500 500
The VIX index tracks S&P 500 options, which are options contracts whose values are derived from the Standard & Poor’s 500 index, which is a capitalization-weighted index of 500 stocks in the United States of America. They grant the trader the right, but not the responsibility, to trade the S&P 500 index at a predetermined price and before a predetermined expiration date.
You would have the right to purchase shares of the S&P 500 at a certain price under a call option, while you could sell shares of the S&P 500 at a specific price under a put option. The strike price is the price at which you decide to buy or sell the underlying market at the time you make your decision.
Understanding the VIX indexes
There is a substantial negative association between the VIX and the performance of the stock market. A rise in the VIX indicates that investors’ worries are mounting, which means that the S&P500 is likely to be dropping in value. If the volatility index continues to drop, the S&P500 is likely to be experiencing stability, and investors are likely to be experiencing a low level of stress. In contrast to a market downturn, trading volatility is not the same as a market fall, as it is conceivable for the market to decline while volatility remains low.
When it comes to financial assets, volatility is a measure of the change in the price of an asset rather than the price of the item itself. Therefore, while trading volatility, you are not concerned with the direction of change, but rather with the amount of movement that has occurred and how frequently movement happens. This is why the VIX index is expressed as a percentage of the total.
It has been widely accepted for several years that if the VIX is trading below 20, the market is experiencing stability and that readings of 30 or higher suggest severe volatility. The VIX has been trading below 20 for several years.
According to popular belief, the VIX is able to anticipate peaks and bottoms in the SPX: when it reaches extreme highs, it is regarded as an indication of imminent bullish pressure on the S&P500, and when it reaches extreme lows, it is regarded as a sign of impending negative pressure on the S&P500. There is even a cliché that suggests that when the VIX is high, it is a good time to purchase stocks. When the VIX is at a low point, keep an eye out for danger below.
As is true with all indices, when you trade the VIX, you are not directly trading an asset because there is no tangible item to purchase or sell, as there is with other indices. To trade the VIX, you can use derivative instruments that are designed to mirror the price of the volatility index, rather than directly trading the index.
When trading the VIX, you may utilize CFDs, futures, and exchange-traded funds to take a position on the movement of the index (ETFs). Keep in mind that we price our VIX index in a different manner than we price our other cash index markets. We apply the same process that we used to obtain our updated commodities, which is to create a price between the two nearest futures contracts on the underlying market because these are the markets that are often the most liquid.
Make a decision on whether to go long or short on the VIX index.
Long and short bets are the two fundamental types of VIX positions that may be taken when opening a trade. Volatility traders are not concerned with whether the price of the S&P 500 will grow or decrease, since they may profit from either outcome — instead, volatility traders are searching for signs that the market is becoming more unpredictable.
Taking a long position in the VIX
In order to choose which position to take, you must first determine what amount of volatility you anticipate. Volatility traders, also known as long VIX traders, are individuals who believe that volatility is likely to grow, causing the VIX to climb. A common strategy during times of financial instability, when there is a lot of stress and uncertainty in the market, is to go long on the VIX (the volatility index).
In the case of a political announcement, for example, you may take a long view on volatility if you believe that the S&P500 would undergo a substantial and quick decrease. This might be accomplished by initiating a trade to purchase the VIX.
If there had been volatility, your forecast would have been true, and you would have been able to realize a return on your investment. If, on the other hand, you had taken a long position at a period of low volatility in the market, your position would have incurred a loss as a result.
Taking a short position on the VIX
A short bet on the VIX is simply a prediction that the S&P500 will gain value in the foreseeable future. Short-selling volatility is particularly popular when interest rates are low, economic growth is decent, and volatility across financial markets is low, as is the case right now.
Assume that the combination of low volatility and strong economic growth has resulted in a consistent increase in the share prices of the constituents of the S&P 500 index. You can elect to short volatility in the hope that the stock market will continue to rise while volatility remains low. This is a risky strategy.
You might make money if the S&P500 continues to increase since the VIX is expected to fall to a lower level, allowing you to make a profit. When it comes to shorting volatility, the risk is inherent, as the possibility for endless loss exists if volatility surges unexpectedly.
Futures and options on the VIX index
Investors with a higher level of sophistication can also trade options and futures contracts based on the VIX index itself. Options and futures provide investors with more leverage, and as a result, the opportunity for bigger returns on a successful investment. Having said that, there are a few considerations for investors to bear in mind. 1. Options and futures trades are often subject to greater commissions than stock trades, and futures traders will be required to maintain a minimum margin level in order to trade. It is also important for investors to be aware of the differing tax treatment for gains and losses, which is particularly true for futures contracts. 4 Options and futures are also assets with a defined lifespan, which means that investors must be correct not only about the direction of volatility but also about the timeframe in which it will occur.
VIX options are European-style options, which means that they may only be exercised at the time of expiration of the contract. Furthermore, these options expire on Wednesdays (as opposed to the more conventional Friday expiry for options), and settlements are made in cash rather than in stock certificates. 5 The built-in leverage of options allows for greater profits to be realized; however, investors should be aware that these options trade on predicted forward value and can diverge from the current VIX index.
Instead, because of the European-style exercise and the volatility’s normalization, VIX options will frequently trade at a lower value than what appears logical during periods of high volatility (and vice versa during periods of low volatility), particularly early in the option’s life cycle.
The VIX futures contract, like options, is intrinsically leveraged, and they tend to better reflect the swings of the spot VIX index than the ETNs. Investors should be aware that the value of the futures contract is based on a forward-looking evaluation of the VIX index once again. Depending on the outlook and the length of time remaining before settlement, actual futures prices might be lower, higher, or equal to the spot VIX price.
Furthermore, there have been suspicions of VIX manipulation, and investors who have been caught on the wrong side of large fluctuations have suffered enormous losses.
Alternative Volatility Management Techniques
The use of the VIX and VIX-related derivatives to trade on the volatility of the markets is not required by any rule. In reality, VIX products may be less than perfect hedges in many situations, whether due to cost, time horizon, or variations between a portfolio’s beta and the market. Certain option methods may be worth considering for investors who are looking for extra investment options.
Strangles and straddles are a valid strategy for trading the predicted volatility of an index or a specific investment, among other things.
In order to execute a long straddle strategy, one must first purchase both a call and a put option on the same securities with the same strike price and expiry date. Because the maximum loss is restricted to the number of premiums paid for the two options (plus fees), the potential gain is limitless, and the investor profits as soon as the price moved sufficiently above (or below) the strike price to recover the number of premiums paid and commissions paid.
For example, to construct a strangle, an investor would purchase two call options and one put option on the same underlying securities, each with the same expiration but different strike prices. Using a strangle has the primary advantage of being less expensive to purchase, but it also requires a higher price change to generate a profit than other types of options.
To Put It Another Way
If an investor’s primary goal is to hedge market risk, a straightforward index put may be the most cost-effective strategy. Put options are available on practically every major equity index, and they are often extremely liquid in the market. Puts are a very simple way to protect against the risk of short-term market declines. Investors must be careful to calculate their exposure correctly (for example, buying S&P 500 puts to hedge a portfolio that is only loosely correlated with the S&P 500 will not provide as much protection), but puts are a very simple way to protect against the risk of short-term market declines.
While the majority of investors seek to avoid volatility, some welcome it and even seek to profit from it in some cases. Electronic trading notes (ETNs) may be a smart alternative for individuals trying to play a specific sentiment about near-term market volatility, although options and futures provide traders with more bang for their dollars. Given the disadvantages and costs associated with VIX-related investments, investors seeking to hedge their portfolios may choose to explore ordinary put options as a more cost-effective alternative to VIX-related investments.