How to Trade Volatility Index (VIX)?
Traders have always been trying to analyze and forecast future price movements. There are plenty of ways of making such forecasts and analyses. Some use chart patterns, some construct complicated trading systems based on indicators. However, there is always an alternative to all these approaches, which is VIX analysis.
This instrument is the index of future volatility of the US stock market. It is also known as "the fear index" because it can demonstrate the market sentiment. When the index values grow, this might mean that the market is expecting serious movements, such as corrections or even global crises. This information, in turn, can be used for making trading decisions.
This article is devoted to VIX and the ways of trading it and its derivatives.
What is VIX?
VIX, or the Volatility Index, was created in 1993 in Chicago Board Options Exchange. Speaking rather particularly, it represents the opinion of traders on the stock market behavior over the next 30 days.
VIX is calculated by the Black-Scholes formula based on 8 stocks from the S&P 500. VIX values can give an idea of how volatile next market movements will be, and this information, in turn, might help investors make a good trading decision.
Some say that market volatility will grow alone guide the growth of the index values. And if the index values are low, the market will remain stable, while any expectations of volatility surges or some malfunctions in the global economy will be useless.
For example, in March 2020, the index values rose extremely high, reaching the level of 2008 when the world got immersed in a tremendous economic crisis. Indeed, the beginning of 2020 was rather unstable, and investors were pretty scared, which resulted in a serious slump of stocks.
Now it is clear that while the market is falling deeper and deeper, panic and uncertainty among investors only grows, and VIX values rise. With VIX, you can try catching the beginning of panic as well as its potential end and start buying cheaper shares without any hurry.
How to use VIX?
Some say that it was the financial crisis of the banking sector that heated the interest of traders towards volatility so badly. To satisfy the demand, there appeared products that facilitated investments in ETFs and notes via VIX.
On the one hand, such investments let you make a profit on VIX movements or hedge risks of possible market slumps. As a result, the expectation of increased market volatility and buying VIX or its derivatives might compensate for a drawdown in your portfolio when the market really slumps into a lengthy correction.
Opening a position in VIX, you can cover up for other stock trades in your portfolio and insure your market positions. For example, if a trader buys stocks included in the S&P 500 and looks for smoothing out possible consequences of the short-term volatility growth, they may open a buying trade in VIX to decrease risks of corrections in stocks. And if the trader is mistaken, and volatility did not grow, the profit from buying the stock compensates for losses from the long position in VIX.
How to trade VIX?
Most often, the fear index is invested in via ETFs or ETNs. Let us focus on some of the instruments.
ProShares VIX Short-Term Futures ETF (VIXY)
This is a rather popular instrument among other ETFs. It represents the volatility dynamics of VIX based on the S&P 500 VIX Short-Term Futures Index, which, in turn, consists of a set of short-term VIX futures.
However, I would recommend VIXY to experienced investors only. As a rule, when the investor understands well what they need, they either try to make a profit on the growth of the S&P 500 volatility or hedges from a significant market slump.
iPath B S&P 500 VIX Short-Term Futures ETN (VXX)
This one is a popular instrument among ETNs. It offers an access to a daily moving long position in VIX futures of the first and second month. VXX represents expectations of investors about the future direction of VIX at the moment when its futures expire.
The asset is volatile, and its movements can reach 10% a day, but high risks mean high potential profit that might be interesting for aggressive traders. Note that VIX movements may have no correlation with VXX, there is a certain lag.
Traders also note that VXX does not suit long positions but it still has negative correlation with the S&P 500. Hence, in large corrections, traders can make money on the growth of volatility with iPath B S&P 500 VIX Short-Term Futures ETN (VXX).
In essence, VIX represents the volatility of the US stock market. If its values rise high, investors are afraid of an approaching market correction. And if VIX values are low, this means investors are confident about future market growth.
Note that investments in VIX are thought to be risky, recommended to short-term and aggressive investors only. The "buy and hold" principle is useless here, you will have to keep tracking trades and market behavior on the whole to avoid serious losses.
The best time to invest in volatility is a financial crisis because market players will freak out and sell their assets, which will provoke the growth of volatility and a surge in VIX.
Do not forget about derivatives, such as ETFs and ETNs: they are available and easy to sell and buy as any stocks in the market.