Introduction to the VIX
The volatility index also referred to just as the VIX, is a common barometer and benchmark that represents overall market sentiment. The VIX is one of the most vital tools for retail traders when they assess the level of risk in the market.
The VIX also represents a viable opportunity for traders and investors to capitalize on the market volatile itself if traders use the right trading strategies to do so.
The VIX was created by the Chicago Board Options Exchange (CBOE), and it was the initial benchmark that was used to quantify the expectation of market volatility.
The VIX is forward-looking, which simply means that it can show the implied volatility within the Standards and Poor’s (S&P) 500 a month ahead of time.
By using the prices on the SPX index options, the VIX can be calculated and expressed as a percentage. When the value of the VIX increases, it shows that the S&P 500 is experiencing a decline, and if the value of the VIX falls, it indicates that the S&P 500 is experiencing a time of stability.
The VIX is used to measure the level of market stability in the S&P500, but it can also be used as an overall indication of health in the US stock market.
Prices in the stock market increase when retail traders and investors start showing interest in a specific security, which means that the price of options can be used as an accurate measure of volatility.
This function has led to the VIX often being referred to as the “fear index” and the reason is that the VIX tends to measure the level of market fear and stress.
One thing that traders and investors who are interested in trading the VIX must remember, is that current volatility in the market cannot be predicted ahead of time. For this reason, the VIX must be used alongside historical analysis on both support and resistance lines on securities.
The Relationship between the VIX and S&P500
The VIX tends to rise in bearish stock market conditions while it tends to fall when there are bullish environments. Bearish trends refer to downward trends in prices while bullish typically refers to increases in prices.
These conditions occur because of the overall long-term bias that exists in the stock market combined with the fact that the VIX is calculated through implied volatility.
When there is an extremely strong demand for securities, the implied volatility in the market will increase drastically. This is attributed to the fact that typically bullish market participants will quickly buy safe assets to protect their portfolios against market volatility.
When the S&P500 rallies against bearish trends, the demand for protection will start dissipating and this will cause the VIX to decline in response.
Why do traders trade the VIX-75?
Financial instruments that are linked to the VIX-75 will automatically present negative correlations with the stock market.
This makes these financial instruments extremely attractive to professional traders and retail investors because they provide diversification and hedging, along with several pure speculation trading opportunities.
When a stock trader or investor takes a trading position in the VIX they could balance out different stock positions within the same investment portfolio and this will subsequently hedge the market exposure of the trader or investor.
The VIX can be traded in several ways including individual stocks, exchange-traded funds (ETFs), which are baskets of shares, and exchange-traded notes (ETNs) which are tied directly to the VIX.
How beginners can manage their risks in volatile markets
The VIX can be used to earn significant profits, but only if traders are smart about it. Going into a trade blindly is one of the best ways to deplete a trading account in record timing. Trading carries inherent risks, and it is not something that will change, but traders can protect themselves and safeguard their funds.
Whether experienced traders want to step up to a new challenge in trading the VIX or beginner traders want to move from foreign exchange trading to something new, risk management is the most important thing that must form part of every solid trading strategy.
Risk management tools, techniques, and strategies are something that every trader must familiarise themselves with and use religiously and without fail in every trade, especially when trading volatile markets.
Volatile markets offer a significant number of profitable opportunities, but the opposite is always likely to happen, and traders can lose their capital.
Small Position Sizes
Sizing down positions, or controlling position sizes correctly, when trading volatile markets is one of the best risk management strategies. Focussing on only a couple of positions instead of several helps traders keep to their trading plan and strategy.
It also limits the chances that traders start trading on their emotions, which could be detrimental to their trading. When traders hold too many positions or they have positions that are too large, a volatile market can lead to significant losses drastically and rapidly.
Hedge Risks
When traders trade safer options on any given trading day, such as vanilla options, along with spot trades, they can effectively manage their risk because traders can hedge the risks of their spot trades.
Options are one of the safest options to hedge risks because the trader’s premium is the total that they can lose.
Wider Stop-Losses
When traders are faced with massive price swings in a volatile market on a certain trading day, they can panic, and this can lead to emotional trading.
During such times, trading strategies can seem like they are ineffective, and traders may start questioning their strategies. When traders do not trust their trading plan, they could start making irrational decisions and quicker they will try to adjust the way they trade to try and counter loss.
This can be detrimental and one of the best ways to stop this is for traders to place their stop-loss orders at wider intervals, which ensures that traders do not exit their trades too early.
How can beginners trade the VIX-75 Index?
There is no holy grail to successfully trade the Volatility 75 Index and the pattern of trading the VIX is like trading currency pairs. The same way that traders participate in the forex market can be applied when stock trading the VIX 75.
Some important components surrounding the VIX include support and resistance, price action, and market structure. Some of the most popular VIX trading strategies are based either on reversals or on mean-reversion.
Trading VIX Volatility
One of the best ways in which novice and experienced traders can go about trading VIX relates to trading its volatility by using basic technical indicators.
This involves the Bollinger Bands, a volatility indicator that can plot a channel that is two standard deviations from a moving average on a price chart.
Trading VIX Reversals
The reversal strategy uses the mean-reversion characteristics relating to the VIX index.
It uses the same approach that is used in volatility strategies, but all trading decisions that the trader makes are based on moving averages, including the fact that there will be an open trade in the market.
Trading VIX Divergences
This involves trading divergences that exist between the underlying stock index and the index. The VIX’s value is derived from implied volatility associated with the S&P500, which is why the two instruments are so closely correlated to one another.
The VIX Divergence strategy takes advantage of this correlation by trying to predict entry and exit points for trades.
Trade using Breakouts
Traders tend to act in herds, which can cause a domino effect in stock trading. However, some levels can break violently when too many traders notice them, and the stop-orders start piling up around the edges of these levels.
instead of trying to identify where the market may turn around revolves around poaching the level and trading the breakout instead. The aim is to find the perfect level that can be exploited and place an order before the market can reach this point.
Traders must keep their stop-loss limits and their take-profit targets within a comfortable striking distance of the spikes in the market.
FAQ
How does CFD trading on spot indices work?
A contract for difference (CFD) is a contract that is created between the buyer and seller of a security. The buyer agrees to purchase the security for the price difference between the current market price and the price when the contract ends.
What is Index Trading?
This is a figure that represents the health of an overall market or an economy. With index trading traders can invest in a large segment of a market and traders can speculate whether the index will appreciate or depreciate.
What is the CBOE Volatility Index (VIX)?
It can be defined as a real-time index that represents the expectations of the market regarding the relative strength in near-term changes that relate to the Standards and Poor’s (S&P) 500.
What is the relationship between the VIX and the S&P500?
When the S&P500 rises or falls, the VIX corresponds in the opposite direction. If the S&P 500 increases, the VIX falls, and if the S&P 500 decreases, the VIX will increase.
How is volatility measured?
Volatility can be measured using two different methods, with the first relating to statistical calculations done on historical prices according to a specific period. The second involves inferring the value as it is implied by different option prices.
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