The volatility index is also called the VIX index. It launched on the Chicago Board of Options Exchange (CBOE) in 1993. Professor E. Whaley originally developed it in collaboration with the CBOE.
The VIX measures and quantifies the market expectations for volatility in the S&P 500 index for the upcoming 30-day period, which measures market risk. When the VIX value rises, traders expect a significant price swing in the S&P 500 index in the next 30 days. When it drops, traders don't expect significant price swings in the next 30 days and expect low volatility, often attributed to complacency. There is no VIX stock, and it doesn’t impact penny stocks much unless they correlate to the S&P 500.
While the VIX is technically a non-directional indicator, it has a historically strong inverse relationship with the S&P 500 index. While this tends to occur most of the time, it doesn’t occur every time. When the VIX moves sharply higher, the S&P 500 index and stocks tend to fall swiftly. This negative correlation represents the inverse relationship indicated with the red arrows in the VIX indicator chart with the S&P 500 index NYSEARCA: SPY and the VIX.
When the VIX collapses, the S&P 500 index tends to rise sharply. However, there are instances where the VIX moves in the same direction as the VIX, called positive correlation, indicated by the green arrows in the above chart. Many traders scratch their heads until they realize that a spiking VIX projects a larger price move, but not always the direction. Even judging by the SPY chart, the VIX tends to correlate with the VIX most of the time negatively, but not always. The positive correlation can happen during volatile periods driven by major economic news, including interest rate announcements, CPI reports, bellwether earnings reports and conference calls, pandemics or geopolitical and news events. This is very important to remember as many traders have blown up their accounts, forgetting this possibility.
What is Volatility?
It might be easy to assume that VIX volatility index is synonymous with a falling market. More volatility ensures a deeper falling market since you usually hear about VIX because it's often associated with a falling market. The VIX often rises when markets fall. Again, the VIX is not supposed to be a directional indicator. Still, it moves inversely with the S&P 500 index, which is often associated with VIX meaning.
However, volatility doesn't equate to just a falling market. Volatility relates to the magnitude and velocity of a stock or market price fluctuations. It's a statistical measure of the spread of returns over a while. Volatility is the rate of change in the price of a security. There are two types of volatility: historical and implied.
Historical volatility (HV) measures a stock's price fluctuations (e.g., 30 days) as an annualized standard deviation of daily returns. Implied volatility (IV) aims to predict future volatility derived from the underlying pricing of options contracts.
If a stock's options activity telegraphs expectations for a large price move, then implied volatility rises. When IV rises, the cost of an options contract gets more expensive as it impacts the options premium.
What Does the VIX Measure?
The VIX measures market risk and is often called the "fear" index. Specifically, it measures the expected 30-day volatility of the S&P 500.
It doesn't measure current or historical volatility but future or implied volatility. It's derived from the S&P 500 index options activity, including calls and puts. It also measures the market sentiment with a low VIX indicating low volatility and small price swings and a high VIX indicating large and large price swings.
It measures the market risk and enables traders to quantify and visualize it on a chart. While it's not originally intended as a directional indicator, you can't deny the inverse relationship the VIX has with the S&P 500 index most of the time.
How to Use the VIX
You can utilize the VIX in many different ways — as an indicator to gauge the market sentiment. When the VIX is low, it suggests low volatility in the stock market, which is generally trending up.
The longer the VIX stays low, the more complacency sets in, which can be dangerous since it opens the possibility of a spike when volatility returns. A high VIX indicates fear as the market may sell off and sharply fall lower. Many traders will use a low VIX to consider shorting the market, trying to take advantage of a reversal. Many traders will use a high VIX reading to buy into the selling, looking for the market to bottom and reverse. Unfortunately, the trend can continue progressing as a low VIX tends to continue lower and vice versa until they reach extreme levels.
You can also use the VIX to hedge a long portfolio. Traders and investors may consider hedging a long position by taking an inverse VIX ETF, which usually rises in value when the S&P 500 falls. However, that's not always the case, as they can positively correlate at the strangest times. You can also trade the VIX with options and futures.
How to Trade the VIX
Technically, the VIX is an index like the S&P 500 index. You can't trade it directly, but you can with various exchange-traded funds (ETFs) and exchange-traded notes (ETN). You can use the iPath Series B S&P 500 VIX Short-Term Futures ETN BATS: VXX in the short term to trade the VIX. It has some of the most liquidity of the ETNs and ETFs, with over seven million daily shares traded. Remember that this ETN experiences time decay due to contango, and you can't hold it long-term.
There are also inverse ETFs like the ProShares Short VIX Short-Term Futures ETF BATS: SVXY designed to mirror the one-day move of the VIX. Arguably, the most popular inverse VIX ETF is the tripled leverage ProShares Ultra VIX Short-Term Futures ETF BATS: UVXY, designed to move three times the one-day price movement of the VIX. Remember that the VIX is a number reading, not a price or dollar value.
Trading the VIX through ETFs will derive a dollar price, which may not always equal the number value of the VIX. It's important to remember this as traders can sometimes get the value of the VIX mixed up with the price of the ETF of the VIX.
How to Calculate VIX Values
While using the latest VIX quoted values is much easier and practical, you can attempt to calculate it manually. The VIX is the annualized 30-day implied volatility of the S&P 500.
It’s calculated daily by averaging the weighted prices of a predetermined group of put and call options, usually more than 100 puts and calls. It calculates the index by calculating the index using weekly and monthly S&P 500 options with more than 23 days and less than 37 days ahead of expiration. The selection of the options contracts is proprietary. It varies from calculation to calculation, but the VIX is more sensitive to changes in the prices of the lower strike options and less to the higher strike-priced options.
According to S&P Global, there are four steps to calculating the expected range of the S&P 500 using the VIX.
First, convert the VIX level to an annual percentage. Then, divide the annual percentage by the square root 12 for the 30-day implied volatility.
Next, multiply the current S&P 500 with the 30-day implied volatility, calculating the potential impact on the index level.
Finally, establish the expected range of the S&P 500 level by calculating the lower and upper levels.
Examples of Trading the VIX
What is VIX stock? We will use the SPY as a trading vehicle to play the VIX signals. As mentioned, you can't trade the VIX directly. You can trade a VIX ETF and treat it like a stock. However, the more common and widely used trading is playing the inverse relationship to the SPY. When the VIX rises, the SPY tends to fall, and when the SPY falls, the VIX tends to rise.
The SPY (top chart) and VIX (lower chart) illustrate the inverse relationship. As the SPY rises, the VIX below falls. The opportunity to trade off the VIX peak occurs on August 24.
The VIX peaks at 17.21, causing the relative strength index (RSI) to reject its bounce attempt at the 60-band and move lower, indicating distribution selling. The SPY chart indicates a bottom and long trigger at $436.89 as the stochastic triggers a buy signal as it crosses back up off the 20-band. This indicates that buying momentum is coming into the stock. Both instruments trigger their respective reversal signal using a momentum indicator.
The SPY eventually rallies to a peak of $451.19 on September 1 before falling as the stochastic oscillator falls under the overbought 80-band. The VIX falls to a low of 13.08 on September 1 before bouncing as the daily RSI bounces back up from the 37-band.
What Are High and Low VIX Values?
Historically, a VIX that falls under 15 is considered a low value and a VIX above 30 is considered a high value. The range between 15 to 30 is considered moderate, with more turbulence as it gets closer to 30.
Remember that the VIX can fall into single digits, which screams market complacency. These are usually during markets that are strong and slowly grinding higher. They are also prone to sharp reversals when traders least expect it. The same holds true when the VIX trades above 30. During bear markets, the VIX has shot up to 80, indicating massive market fear and the proverbial "blood in the streets."
During the 2020 pandemic, the VIX spiked massively from 13.68 on February 14, 2020, to 82.69 on March 16, 2020. The SPY fell from $337.42 to $239.85 during the same four-week period. The magnitude of the panic plunge in the SPY caused the VIX to skyrocket to panic highs simultaneously.
Incidentally, the negative correlation turned positive when the SPY continued to make a new low of $222.95, and the VIX also fell to $ 61.59. This positive correlation was a divergence trigger, often a signal for a potential reversal in the SPY. That happened as the SPY bottomed out, and the VIX fell under 65. This is another way to use the VIX to spot divergence, which often precedes reversals in the SPY.
Leveraged VIX ETFs
Some ETFs enable you to trade the VIX synthetically, and leveraged ETFs are designed to mirror the single-day price move in the VIX. The leveraged ETFs are widely used as both a trading and a hedging instrument. Leveraged ETFs commonly come as 2X and 3X. The tripled leveraged inverse VIX ETF moves 3X the percentage price move of the VIX on a one-day basis. Remember, these ETFs are designed to decay instead of long-term. Price gaps and contango erode the value of the leveraged ETFs even if the VIX remains flat.
This is why the UVXY routinely does reverse splits once it falls under $5 for an extended time. If you use leveraged ETFs, it's best to hold them short-term, usually less than a week, to limit the decay you absorb.
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