What Is The Volatility Index & How To Trade With It

The Volatility Index, or VIX, is a market index that represents the market’s volatility of the next 30 days. It was created by CBOE (Chicago board options exchange) in 1993 for the S&P 500 Index. Since then, the VIX is commonly used as a gauge of U.S. equity market volatility. The VIX provides a measure of market risk and traders’ sentiments. It is also called “Fear Gauge” or “Fear Index.” The VIX works by tracking the underlying price of S&P 500 options – not the stock market itself.

What is the Volatility Index?

Volatility is the measurement of price movements that asset experiences over a certain period. The stronger the price fluctuations, the higher the volatility of an asset.

The Volatility Index measures the volatility in two ways:

  1. The first method is based on statistical calculations of the historical prices over a certain period. It involves computing various statistical values like mean average and standard deviation of the historical prices.

The value of standard deviation is a measure of volatility. To predict future volatility for specific months, the calculations would be to measure previous months’ volatility and then expect the same pattern would continue.

  1. The second method to measure volatility comprises of the conclusion of the values of option prices. Options are derivatives whose price relies on the movements of an asset to reach a certain level. This is also known as the exercise price or strike price.

Since option prices are available in the open market, they identify the volatility of a particular asset.

How is the Volatility Index calculated?

The VIX measures S&P 500 options, which are options contracts that take their prices from Standard & Poor’s 500 – a capitalisation weighted index of 500 stocks in the US. They give the trader the right, but not the obligation, to trade the S&P 500 at a set price, before a set date of expiry.

VIX index values are calculated using standard SPX options (expires on the third Friday of each month) and the weekly SPX options (expires on all Fridays). The values of SPX options must lie within 23 days and 37 days.

The formula for the VIX Index is:

VIX Index formula
VIX Index formula

Here’s how the formula works:

It estimates the expected volatility by aggregating measure prices of puts and calls over options. A keynote to add here is that this formula is for the S&P 500 Index.

The options should have a non-zero value of the bid and ask prices. Calculations are performed at 3:00 a.m. CT (central time zone) and 9:15 a.m. CT and between 9:30 a.m. CT and 4:15 p.m. CT.

How to use the Volatility Index?

Like all indices, when applying the Volatility Index, traders are not investing directly on an asset. Instead, there are using VIX for finding the highs and lows.

It’s important to remember that volatility traders just want to measure market volatility instead of rising or falling prices for going long or short.

The positions traders take on volatility levels. For taking buy positions, the volatility should increase, making VIX rise. Typically, traders take buy positions when there is a lot of uncertainty in the market. This is called bullish pressure. For example, when there is an upcoming election or political instability, volatility would increase, resulting in favorable buy positons.

For taking sell positions, there should usually be low volatility across the market and making VIX fall. Traders typically take short positions when there are lower interest rates and favorable economic growth. This is known as bearish pressure. For example, if there is steady economic growth in the market, a trader may opt for sell positions.

However, traders must remember that sometimes the volatility can go against their positions, causing severe damage to the trading account. Therefore, traders should not rely solely on the volatility and use other analysis forms with the Volatility Index.

Rather than trading the VIX directly it is possible to use the VIX to trade equities and indices. That’s because when volatility is rising stocks and indices are generally falling, but when the VIX is falling stocks and indices are generally rising. At the very least the VIX can be used as an initial signal to begin looking for signs to buy or sell in the market based on the direction in volatility.

Volatility Index conclusion

The VIX is a real-time volatility index, created by the Chicago Board Options Exchange (CBOE). It was the first benchmark to quantify market expectations of volatility. But the index is forward looking, which means that it only shows the implied volatility of the S&P 500 (SPX) for the next 30 days.

Although it may look confusing for the new traders, the Volatility Index can be a useful trading tool when correctly applied. Traders need to take care of certain aspects like calculations of the Volatility Index and the overall market sentiment.

The Volatility Index can be used on your trading platform charts to help filter potential trading signals as part of an overall trading strategy.

For traders in equity, the VIX is a very good and sound measure of risk in the markets.It gives these stock traders who are in intraday trading and short term traders an idea of whether the volatility is going up or going down in the market. They can calibrate their strategy accordingly.

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