What is the VIX index? How to use the volatility index in your trades

Graph showing a slow uptrend

The VIX is one of the most widely used measures of market volatility, for both the S&P 500 and wider stock market. So, what is the VIX, how is it calculated and how can you take your first position on volatility? Find out below.

What is the CBOE Volatility Index (VIX)?

The CBOE Volatility Index – more commonly known as the VIX – is a real-time index that tracks the market’s expectations of short-term price changes in the S&P 500. It’s an important benchmark for market volatility, risk, stress and sentiment, which is why it’s often referred to as the ‘fear index’.

VIX vs SP 500

The VIX index was introduced in 1993 by the Chicago Board of Options Exchange. It’s grown over the years, and its calculation methodology has been altered to create a broader market benchmark and more accuracy.

How does the VIX work?

The VIX works by tracking the price of at-the-money SPX options with near-term expiration dates. This means it’s not a representation of the price of the underlying S&P 500 itself, but of the price traders are willing to buy and sell the S&P 500 at for the next month.

The more dramatic the price swings in the value of SPX options, the higher the levels of implied volatility and so the higher the VIX value.

SPX options are a combination of standard SPX options that expire on the third Friday of each month and weekly SPX options that expire on all other Fridays. To be included, an option must have an expiry date between 23 and 37 days from the time of calculation.

The VIX calculations are complex, so put simply, the index takes the values of all of the put and call options over a range of strike prices and deduces the market’s perception of which strike prices are likely to be hit before the expiry date from how much people are willing to pay for each option.

The VIX is calculated in real-time from 8am to 2:15am (UTC) and from 2:30am to 9:15pm (UTC).

What does the VIX volatility index tell us?

The VIX tells us the market’s expectation of volatility, rather than current or historic market levels. Because of this, it is considered a leading indicator for the wider stock market.

Other measures of volatility, such as the ATR indicator or Bollinger Bands, are based on past movement – making them lagging indicators. The VIX is highly valued because it tells you whether implied volatility is set to spike in the coming month.

A common mistake when reading the VIX is to believe that it tells us whether the S&P 500 is being bought or sold. While the VIX and S&P 500 do usually have an inverse relationship, the VIX is a measure of volatility itself – and in theory these price movements could go both ways.

Another common misconception is that VIX levels have an exact relationship with the volatility seen 30 days later, when in reality the VIX level is often slightly above – or trading at a premium to – the actual volatility. This is because when the time comes around, the market has usually adjusted to the volatility.

How do you read the VIX?

The VIX is presented as a percentage, so the indicator fluctuates between 0 and 100, much like a typical oscillator. You read the VIX using known levels of support and resistance; these are:

  • Below 12 = low volatility
  • Between 12 and 20 = normal volatility
  • Above 20 = high volatility

When the VIX is above 20, it typically indicates a high degree of fear in the market – the S&P 500 is volatile, and expectations are high for stocks to fall in value. When it is low, it means that fear levels are lower.

However, there’s been a traditional mantra of ‘When the VIX is high, it’s time to buy. When the VIX is low, look out below’.

What does it mean when the VIX goes up?

When the VIX goes up in value, it means the price of the S&P 500 is likely falling and the values of SPX put options are increasing. Analysts interpret these high values to mean that investors are uncertain or fearful about the stock market.

If investors are fearful why is it time to buy? The theory goes that when there are high levels of volatility in the market, a bottom or support level has been found and the market is going to change direction. This is why the common action is to buy when the VIX reaches high levels.

What does it mean when the VIX goes down?

When the VIX falls in value, it usually means that the price of the S&P 500 is rising in price or experiencing relative stability – leading SPX options investors to pursue bullish or neutral strategies.

Analysts would interpret these low to middle values as a sign that the market is experiencing little stress or concern. Some traders take low VIX values as bearish signals, and and close their positions because they believe the calm markets signify the end of a rally.

How do you use the VIX?

There are two typical ways to use the VIX: as a measure of general market sentiment, and as a market to trade.

Using the VIX to measure market sentiment

You can use the VIX as part of a trading strategy as it can give indications of whether the S&P 500, and stock market in general, is going to reverse from its current trend.

As mentioned above, when the VIX hits highs, it’s often seen as a time to buy the market, and when it makes lows, it’s seen as a bullish signal. However, this strategy should be taken within a wider methodology of technical and fundamental analysis to confirm the entry and exit points the VIX suggests.

It’s important to note that the VIX can remain high or low for significant periods of time, so the signals it gives off might not necessarily indicate an immediate reversal. For example, when the COVID-19 pandemic hit in early 2020, the VIX climbed higher than 80 – a level it hadn’t experienced since the last financial crisis in late 2008. It took the VIX until December 2020 to fall below the 20 mark again.

Trading the VIX itself

You can also use derivatives such as futures, options and CFDs to take a position on the VIX index directly. Here, you’re speculating on whether the VIX will go up or down – not using it as a measure of wider sentiment.

You might, for example, believe that S&P 500 volatility is set to spike over the coming months, but notice that the VIX hasn’t yet risen. By buying VIX CFDs, you can earn a profit if the VIX rises. If it falls, though, you’ll earn a loss.

Another popular reason for trading the VIX is as a hedging tool. As we cover above, VIX and the S&P 500 usually have an inverse relationship. So, when the VIX is rising or falling, the S&P will likely be doing the opposite.

Traders use this to hedge their existing S&P 500 positions. If you’re worried that your long S&P 500 position will incur a loss due to a short-term pullback, you could buy the VIX – then, if the VIX spikes as the S&P falls, your volatility index trade will offset the loss from your existing position.

How to trade the VIX

Take a position on whether the VIX is rising or falling in four easy steps:

  1. Open an account with City Index or log in to your existing account
  2. Search ‘Volatility index’ in our award-winning platform
  3. Choose your position and size, and your stop and limit levels
  4. Place the trade and monitor the market

Alternatively, you could practise trading the VIX in a risk-free environment first, using our demo account.

VIX FAQs

Does the VIX affect options prices?

Yes, the VIX can have a significant effect on the prices of stock options, which are based on volatility among other factors. A higher VIX usually means that options prices will rise, while a lower VIX means they fall.

Can you use the VIX for diversification?

The VIX volatility index is a popular method of diversifying your trading portfolio, as it often has an inverse relationship to other markets such as US stocks. By using a derivative to trade the VIX directly, you can help protect your portfolio against market risk.

What is the difference between the S&P 500 and the VIX?

The S&P 500 is a stock index that measures the prices of the top 500 listed US companies. The VIX is a volatility index that tracks how much the S&P 500 might move in the coming 30 days, based on activity in the options market.

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