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What is the VIX and how do you trade it?

Disclaimer: This article is an educational guide to CFD trading and the financial markets and should not be considered as advice. Trading CFDs is high risk. Always ensure you understand the potential risks and rewards associated with trading before you trade.

Introduction

The VIX, commonly known as the volatility index or ‘fear index’, is a headline metric used by traders to predict market volatility. The VIX measures expected future volatility in the US stock market and is the responsibility of the Chicago Board Options Exchange (CBOE) who update the index daily. The VIX can be any value from 0 to infinity, but the highest figure recorded to date – in 2020 – is 82. The metric is derived from the weighted prices of call and put options on the S&P500 index for the next 30 days, giving a rolling measure of implied volatility. This ability to predict future volatility makes the VIX one of the most important headline measures for traders. But how does it work? It all rests on the market’s use of options. Because options are used to hedge long equity positions, the market expectation for volatility is implicitly embedded in options prices, with traders seeking more protection when markets are more volatile. Traders can use the VIX to inform their own trading or directly share in the price action of the index via CFDs.

 

Definition and purpose

The VIX gives a figure for implied volatility by looking at the weighted prices of a group of options, rather than similar metrics that use historical price fluctuations. Implied volatility shows expected future market movements, as traders spend money on options to hedge positions in the equity market. High levels of expected uncertainty drive up the CBOE VIX, while periods of reduced anxiety, and expected stable prices, result in lower values. Normally, the implied volatility in the VIX then translates into real volatility in the market, which can be measured as historical volatility by backwards-looking metrics.

Initially introduced by CBOE Global Markets in 1993, the original VIX index calculated implied volatility from the price of eight S&P 100 put and call options. In 2002, CBOE expanded its scope to encompass the entire S&P 500, aiming for a broader market representation, with any put or call option with 23 to 37 days to expiry eligible. The evolution continued with the inclusion of VIX futures in 2004, followed by VIX options in 2006. It is important to note that the exact number of options included varies but is always at least 100 and therefore provides a good overall proxy for market sentiment. The time frame of 23 to 37 days is used because the CBOE volatility index aims to produce an implied volatility figure for the next 30 days, so only options with expiry dates within a week of that are given. Historically, the VIX is inversely correlated with future S&P500 price values, so when VIX increases, the stock market often falls.

 

Calculating the VIX

Traders do not need to calculate the VIX themselves, since it is a well-publicised index, and parts of the calculation such as weighting selected options are complex. Even so it is helpful to know how the calculation works for a fuller understanding of this important metric. After collecting options prices, using only those where there is both a bid and ask price available in the market, their prices are weighted according to the distance of their strike price, with options with lower strikes (closer to current market values) weighing more than high strike options. Using different options with the same expiry gives us the variance. Since volatility is the square root of variance for the period selected, you can now calculate the VIX, making sure to multiply the result of the last calculation by 100 to get a VIX index figure.

 

Using the VIX

Since its development in the early 1990s, investors, analysts, and portfolio managers have used the CBOE Volatility Index as an indicator of market stress, influencing their decision-making and often defining whether the market is in ‘risk on’ or ‘risk off’ conditions. Higher VIX figures can push market participants to opt for less risky investment strategies, cycling into safe haven assets such as gold and government bonds, and closing or reducing volatile equity positions. This process can begin whenever there is an increase in the VIX, with absolute levels considered moderately high above 20 and very high above 30. The all-time record for the VIX is 82, set in 2020. In general, higher values indicate a risk off trading strategy is appropriate, whereas when the VIX is lower investors are more confident and rotate into risk on assets.

Volatility and markets

In the general market, volatility can be traded directly through options, with options traders sometimes referred to as volatility traders or ‘vol’ traders. ADSS clients trade volatility using CFDs on indices, like the VIX and Volatility 75 index, which allow traders to speculate directly on movements in the VIX. The flexibility of contracts for difference allows you to trade the product directly – which is not a fund or purchasable asset – allowing for great flexibility in your exposure to volatility. Trading volatility directly is a good way of profiting on general market turmoil, but VIX CFD positions are not long-term investments and should only be used for day trading or on a horizon of a few days.

Traders use the VIX in multiple ways. One of the most basic uses of the VIX is to identify risk on and risk off market conditions. When the VIX is elevated compared to its long run average you can usually assume markets are moving into risk off territory. Risk on conditions tend to prevail when the VIX is low, as traders are less concerned about future market moves and are not buying protection. As mentioned above it is difficult to give an exact figure, since the but 20 for moderate volatility and 30 for extreme volatility are widely recognised levels. The VIX normally trends sidewise for long periods, with small spikes around individual market events such as economic announcements or brief upsets in asset prices. Periodically, the index spikes dramatically as traders worldwide respond to negative news, falling asset prices, and associated market turmoil. It is important to see the current level of the VIX relative to recent values; this is an index best looked at on a chart, as an isolated value for a single time period doesn’t tell you much about real conditions.

 

Risk on

Risk on conditions can be seen on the VIX index when it is low, fluctuating below 20. The usual reason for sustained low periods in the VIX is market optimism, with traders not bothering to pay for protection in the form of options. In risk on market conditions, volatility trading strategies are less effective as the VIX is low and does not fluctuate. Instead, you might want to consider opening long positions on equity CFDs. Other assets that perform well in a risk on environment are industrial commodities like base metals and emerging markets currencies.

 

Risk off

In a risk off environment traders rotate out of equities and industrial commodities and into safe haven assets such as gold, major reserve currencies like the USD, and government bonds. This is normally associated with a downturn in the equity market, and will often follow a spike in the VIX. Volatility index trading is easier when the VIX fluctuates more, so VIX CFD traders look forward to market turmoil that other investors fear.

 

Trading volatility indices

Volatility indexes such as the CBOE VIX and volatility 75 index were set up as market metrics, not tradable assets. One of the great advantages of CFDs is that they can be traded for any underlying where your broker is willing to open a contract, so ADSS clients can benefit from excellent volatility trading opportunities by taking a position on the VIX directly. Volatility trading strategies are a little different from regular trading, since you are tracking a function that is a leading indicator of the market. That means you cannot rely on price data, as the VIX measures implied or expected volatility, and not historical volatility. This means the VIX is sensitive to sudden spikes followed by big corrections, so make sure you have a strategy in place to protect your capital, as losses can exceed deposits.

Trading the VIX directly is an effective way of gaining exposure to overall market volatility, but VIX traders need to bear a few things in mind. Firstly, in highly correlated contemporary markets, traders worldwide use the VIX as a volatility measure, but it is specifically focused on expected volatility in the US stock market. Sometimes local volatility will not show up, and when a period of market volatility is triggered outside of the US it may be a less effective predictor. Many major historical market crashes or recessions have started in other markets before spreading to the US, so the VIX can spike in response to market events outside of the US stock market. VIX strategies for traders include opening a long CFD position when you think market turmoil could appear, or short positions when the VIX is elevated and you believe markets may soon calm down. Because the VIX moves suddenly, trend following strategies are less effective; the VIX has brief intense spikes and then falls, with no prevailing trend direction. Any volatility trade needs to take into account this reality, and it is often wiser to use the VIX as an indicator for equity and index trades, rather than attempting to trade it directly. With volatile markets, it’s always important to remember to use risk management strategies, to mitigate the potential for losses to your capital.

 

Summary

The VIX is a market metric used to identify implied volatility in the US stock market. The size and importance of this market mean the VIX is taken seriously globally, being used by traders around the world to predict future volatility. CFD trades are able to trade VIX like a regular index, but need to understand how the index fluctuates, and how this differs from conventional tradeable assets. Taking long or short positions on the VIX with volatility index trading allows traders to share unusual and interesting payout profiles as well as hedge a larger portfolio. Normally, it is wiser to use the VIX as an indicator for both long and short equity or index CFD positions. Practise trading the VIX today with an ADSS demo account.

FAQs

What is the volatility 75 index?

The volatility 75 index is a variant of the VIX index that also measures volatility in the S&P500. A reading over 20 is generally considered to be a ‘risk off’ environment, where market participants are fearful of future losses. You can trade the volatility 75 index in the same way as the CBOE VIX.

Is the VIX an index like the S&P500?

Though traders discuss ‘the VIX index’, it does not function like normal market indices. You cannot buy the underlying asset of the VIX as it is a calculation based on options prices, that is used to predict future volatility. The only way to directly share in the price action of the VIX is buy using CFDs, which allow you to take out a contract with your broker to exchange the price movement as a cash balance.

What is VIX trading?

VIX trading refers to dealing in CFDs that take the value of the VIX as their underlying. It is a type of volatility trading, but that can also be a broader term referring to options trading or other derivatives. ADSS CFD traders can deal in CFDs on options as well as CFDs on the VIX index. Most traders prefer to use the VIX as an indicator, rather than sharing in price action directly.


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