The only thing certain about the stock market is that there will always be uncertainty. The war that rages between buyers and sellers in the market each day constantly causes the prices of securities to change. When market conditions are extremely volatile, you can expect bigger price fluctuations and more uncertainty. As traders, we need to understand how volatility impacts the market and how to use it to our advantage.
The good news about volatility is that there is a market index that was literally created to measure it. The VIX, or Volatility Index, was introduced by the Chicago Board Options Exchange (CBOE) as a means of gauging the market’s expectations of forward-looking volatility. You might have heard it referred to as the “fear index” or the “fear gauge”, but just because it has scary nicknames doesn’t mean you should be afraid of learning about the VIX.
It’s actually a very good idea to familiarize yourself with the VIX early on in your trading journey and learn how it can be used to your advantage. We will be taking a more in-depth look at the VIX below to help you gain a better understanding of this financial instrument.
What is Volatility?
Before we learn about how the VIX is actually calculated and how to use it to our advantage, we need to understand volatility. Volatility is basically the rate of change in the prices of a security. In more specific terms, it’s the statistical measure of the degree of variation in a security’s trading price over a specific period of time. As you can imagine, determining the volatility of the market and stocks is a big part of becoming a profitable trader.
How to Use the VIX
The VIX is a benchmark index that was designed to provide a look at the market’s expectation of future volatility. It’s calculated by using the implied volatilities of S&P 500 index options and is a reflection of the market’s expected future volatility for the next 30 days. Since it was created in 1993, the VIX has become a widely accepted measure of the U.S. equity market’s overall volatility. Essentially, if you are a trader, you need to be looking at the VIX on a regular basis to help gauge market sentiment.
The mathematical formula that is used to calculate the VIX is a bit complicated, but the truth is it isn’t as difficult to understand as you might think. Generally speaking, the more volatile that the stock market is, the higher the value of the VIX will be. If the stock market is steadily rising in an uptrend, the VIX will typically be quite low. Alternatively, if the market is falling rapidly, market panic ensues and the VIX is higher.
The VIX is quoted in percentage points which approximately translates into the expected change in the S&P 500 index for the next 30-day period. The percentage points are annualized when you look at a VIX quote. That means if the VIX is currently trading at 10, we can theoretically expect a 10% up or down move in the S&P 500 over the next year and a ~0.83% move up or down in the S&P 500 over the next 30-day period. One thing about the VIX that tends to confuse beginners is the fact that the VIX has an inverse relationship to the equity markets. When the market declines, the VIX typically increases in value. If the VIX has a value of 20 or higher, it is considered to be a high volatility market. Keep in mind that the VIX is only a calculation and that you can’t always rely on it to accurately predict the future.
With that said, there are a few ways to use VIX to your advantage depending on your trading style and investment goals. You can actually trade the VIX as a financial instrument if you expect volatility to either increase or decrease in the near future. This is particularly useful if you are interested in buying a hedge for your long portfolio. Most traders rely on the VIX as a means of focusing on market volatility and understanding how the market might move. You can use it to gauge market sentiment and determine if there are high potential trade setups on the horizon.
The bottom line is that you should be checking the VIX periodically to learn about the status of the market and make more educated decisions. The VIX isn’t perfect by any means, but it’s another great tool that traders and investors can use to help themselves stay profitable.