Are you afraid of change in the market?
If you are, you are probably reflected in VIX – the Chicago Board Options Exchange Market Volatility Index, popularly known as the “Fear Index”. This metric measures the implied or expected volatility in the stock market (as reflected in S&P 500 options) over the next 30 days, and is one of the main indicators used by traders today of market volatility.
VIX is not only valuable as a metric for stock trading, though; it can be traded itself, through VIX futures and VIX options. If you understand the mechanism of how VIX works and why it rises or falls, you can position yourself to make a profit using your knowledge as leverage.
Here, we’ll talk more about playing the VIX – including how you can trade VIX futures and options.
History of VIX
VIX was originally discussed in the late 1980’s by financial experts and economists who wanted a way to gauge volatility – how much a market fluctuates in price – in the markets. In 1993, using a formula created by Prof. Robert Whaley, the CBOE introduced the VIX metric.
To put it simply, VIX is designed to reflect the expected the rise and fall of the S&P 500 index over the next 30 days. It achieves this by weighing a range of options that are a part of the S&P 500 index. The current value of VIX is the annualized percentage of change expected in the S&P 500 index over the next month.
For example, if VIX is at 10, then the indicator expects a 10% annualized fluctuation in the index over the next 30 days. In other words, if the trend were to maintain itself for a year, the S&P 500 would go up or down by 10%.
In reality, to obtain a 30-day value, you have to divide the current value by the square root of 12, which is roughly 3.4641. So, in the example above, the monthly expected volatility would be 2.887% – a very low number.
The higher the value, the more the “market” expects volatility. For example, in October, 2011, VIX came in at 45.45. At that point, the indicator expected a fluctuation of roughly 13.12% (45.45 / 3.4641) over the next 30 days. Right now (August 19, 2012), VIX is at 13.45, which is a 30-day fluctuation of 3.88%.
For comparison’s sake, the long-term average of VIX is roughly around 20, which is a 30-day fluctuation of 5.77%.
Trading VIX Futures and Options
You can actually trade based on VIX by using futures and options – which is sometimes confusing because in some ways, VIX functions as a future.
In essence, you’re trading on whether or not you expect VIX to expect the market to fluctuate more or less. That’s a lot of expecting.
Think of it this way – when you get into VIX futures, you are trying to guess if the market will be more or less volatile by the time the futures contract expires. So, if VIX has been very low for an extended period of time, but you expect rough waters ahead for the market, you could purchase a futures contract that has VIX rising over the next month, for example. You would receive a return if the market were more volatile.
The same general principle applies to VIX options.
In this way, VIX futures and options can provide ways to hedge against the market. Let’s say you have several long positions in your portfolio and expect the market to continue to be strong and generate positive returns for you.
If something happens – say, the European market gets a bad GDP report and the American market begins to suffer as a result – you can create a hedge by taking up a call option in VIX that would give you a return if market volatility rose. Note that it doesn’t necessarily mean that the market will head south and lose value; it just means you would benefit if uncertainty (or fear; hence the metric’s nickname) arose.
With this hedge in place, any potential downturn in your long-term positions would be offset to a degree by the increase in VIX.
That’s one mistake people often make using VIX, by the way – assuming that an increase in VIX suggests a decline in market value and a decrease in VIX suggests an increase in market value. VIX is largely price-agnostic; it doesn’t attempt to reflect the absolute value in the market, merely the degree of price fluctuation.
It is true, though, that VIX tends to rise whenever traders largely believe the market is headed for choppy waters. This is because VIX is based off options, which are created, bought, and sold by traders.
Learn what major forces move the markets at large (which can also help you with trading stocks, bonds, or virtually any other asset in general) and you’ll gain an insight into volatility and what can cause the gauge to move up or down.