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.”
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:
- 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.
- 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?
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:
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.
Volatility Index conclusion
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.
I would prefer to use the majority of market analysis such as the Volatility Index on the 1-hour charts and above. I tend to find that these charts contain less market noise than the lower time frames and thus give more reliable signals for my forex trading strategies. This also means that I spend less time staring at charts and can also set alert notifications to let me know when price has reached certain levels, candlestick pattern has been formed or a particular indicator value has been reached.
The Volatility Index is just one method of market analysis amongst thousands. I would not build a trading system alone, but rather combine with other technical indicators such as moving averages, Parabolic SAR, Stochastic Oscillator, RSI, ADX and price action analysis.
Of course, every trading system will generate false signals which is why money management is so important. I would personally be implementing sensible money management and only take traders that give me a favorable risk to reward ratio, ideally of at least 1:3. This means that one losing trade does not wipe out consecutive winners.
The methods of implementing the Volatility Index into a trading strategy that are outlined within this article are just ideas. I would always ensure that I have good money management, trading discipline and a trading plan when using any forex strategy.
Furthermore, I would combine multiple technical analysis, fundamental analysis, price action analysis and sentiment analysis to filter all entries. You should trade forex in a way that suits your own individual style, needs and goals.
If you would like to practice trading with the Volatility Index, you can open an account with a forex broker and download a trading platform. If you are looking for a forex broker, you may wish to view my best forex brokers for some inspiration.