The VIX Explained: What Every Trader Needs to Know

Introduction

The VIX Index, or Volatility Index, often referred to as the “fear gauge,” measures expected future volatility in the U.S. stock market.

Although it’s worth noting that there are VIX variations for gold, oil, and global indices, when people discuss the VIX, they usually refer to the instrument based on the implied (forward looking rather than historical) volatility of S&P 500 index options.

Broadly speaking, the VIX is widely used as an indicator of market sentiment and can signal increasing or decreasing risk depending on its direction. This article aims to clarify how the VIX Index can inform traders about market conditions and discusses ways you can trade this instrument.

What Does the VIX Index Tell Us?

1. Measure of Volatility:
   The VIX calculates the market’s expectations for volatility over the next 30 days. Higher VIX values indicate higher expected volatility, while lower values may be suggestive more potential stability.
2. Market Sentiment Indicator:
   Many investors view the VIX as a barometer of investor sentiment, particularly those of fear, or complacency.A rising VIX can signal increasing fear or uncertainty in the market often associated with adverse economic conditions, data or significant global events, while a falling VIX may indicate complacency or confidence that good or better times after a market shock may be likely.Such movements may be short or longer term in nature dependent of course on the underlying cause of such potential sentiment changes and the perceived longevity of related events and their implications.
3. Non-Directional:
   Although theoretically the VIX doesn’t necessarily correlate with market direction, its true essence is one of an indication about the expected magnitude of price movements, whether up or down.Times of uncertainty, actual or potential, can influence the likelihood of prices moving away from their current positions, thereby increasing volatility.However, it’s worth emphasizing that such uncertainty is usually negative in connotation rather than positive. This is why we often see an inverse relationship between the VIX and the S&P 500.

The Inverse Relationship with the S&P500?

The S&P 500 Index and the VIX Index are often described as inversely correlated. However, it’s crucial to understand the nuances and exceptions to this relationship.

Generally speaking, during periods of high uncertainty or market stress, investors may use options to hedge against potential losses in their stock portfolios, driving up implied volatility, and thus the VIX.

Conversely, when investors are confident, stock prices tend to rise and volatility decreases, invariably causing the VIX to drop.

Potential Exceptions and price considerations

1. Short-term Deviations:
   There can be short-term periods where both the VIX and the S&P 500 move in the same direction. For instance, in a strongly trending bullish market, traders might buy calls (upside options) to leverage their gains, driving up implied volatility and the VIX along with the market.
2. Degree of Movement:
   The inverse relationship doesn’t necessarily imply a 1-to-1 movement (or even a defined multiple of) irrespective of the direction. As an example, the S&P 500 might drop by 1%, but the VIX could surge by as much as 10% or more.Technical analysis may have a part to play in the degree of movement in both instruments as well as any level of continued uncertainty and implications of this going forward
3. Volatility “Clustering”:
   High volatility periods often cluster, meaning that a single significant drop in the S&P 500 might result in a prolonged period of high VIX values and an apparent “slowness” to drop again, even if the market actually starts recovering or appears increasingly likely it may do so. The reason for this is unclear, but logically after a significant market shock there may be prolonged period of market sensitivity before investors are prepared to believe that any ensuing recovery is sustainable.

Practical Applications for Traders and Investors

It is worthwhile briefly outlining the motivations and approaches as to why someone may consider trading outside that of a pure directional play.

1. Hedging:
   When the S&P 500 is doing well but the VIX starts to rise, it might be a warning sign of increasing uncertainty. Investors may choose to hedge their portfolios by buying VIX options or futures/CFDs.
2. Market Timing:
   Some traders use the VIX for market timing. For instance, an extremely high VIX value might indicate a market bottom, while a very low VIX value could suggest a market top.
3. Pairs Trading:
   Sophisticated traders sometimes engage in pairs trading, going long on one index while shorting the other, aiming to profit from the reversion to the mean of the correlation between the two.

How Can You Trade the VIX?

1. VIX Futures and Options:
   These derivatives allow traders to take positions based on their expectations for future changes in volatility. CFDs (contract for difference) based on the VIX futures contracts are also available om many trading platforms as an alternative.
2. Exchange-Traded Products (ETPs):
   ETPs like VIX ETFs and ETNs provide a more accessible way for individual investors to gain exposure to volatility. Again these may be available of some MT5 platforms such as the one offer through GO Marekts, who provide access to US share CFDs including ETFs.
3. Pairs Trading with S&P 500:
   Traders may also consider strategies that involve trading the VIX in conjunction with the S&P 500.Tihs should be consider an approach for experienced traders only with clear strategies to action both entry and exit of such positions.
4. Utilize Technical Analysis:
   Since the VIX is a tradable instrument (whatever the variation in instrument), technical indicators may still be relevant particularly key levels such as support and resistance levels or pivots.

In summary

The VIX index serves as an important gauge of market volatility and sentiment and can be useful as a daily “check in” insight of current market state. Trading the VIX presents opportunities but also unique challenges and risks as well as offering some guidance on market state. In terms of trading opportunities it may be suitable for experienced traders with a solid understanding of the underlying mechanisms.

There are a few different ways to actually trade the VIX, commonly for those using MetaTrader platforms such as you would with GO Markets, a CFD is available that is based on the VIX futures contract.