VIX volatility index “fear index” for options traders and investors

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A Guide to Trading the CBOE Volatility Index (VIX) – The Fear Index

What is the VIX?

It is the ticker symbol for the Chicago Board Options Exchange Market Volatility Index. It measures the implied volatility of S&P 500 index options.

Look at the charts below. The rising volume of the VIX futures/options signals a growing interest in volatility behavior.

Why is the VIX known as the Fear Index?

It is a measure of the market’s near-term expectation of stock market volatility. When it rises, it means that traders expect the market to get volatile.

When things get volatile, uncertainty increases. Uncertainty is one measure of market risk. The higher the risk, the higher the level of fear. This is why many traders call it the Fear Index.

What are the key characteristics of the VIX?

One interesting feature of the VIX is that it has a strong positive skew. It tends to rise a lot more and at a faster rate than it falls.

This positive skew makes sense because it is a proxy for fear. Fear accelerates quickly as panic takes over. But it is not common for fear to subside swiftly.

Another important characteristic is that it reverts to the mean. Measures of value like company stocks can show long-term trends due to fundamental changes. (i.e. not mean reverting) However, it is a measure of volatility and not value.

How do you trade the VIX?

It is an index. It is just a number. You cannot buy and sell a number. What you can do is to buy and sell its derivatives.

Exchange-Traded Funds (ETF) & Exchange-Traded Notes (ETN)

You can use ETFs and ETNs to speculate on its direction. However, they are imperfect replications of its performance.

The most successful example is the iPath S&P 500 VIX Short-Term Futures ETN (VXX). It uses the first and second month VIX futures and rolls them daily.

Other similar exchange-traded products differ in their duration and leverage. (e.g. VXZ, VIIX, TVIX, UVXY, VIXY)

There are also products that aim to produce an inverse performance. (e.g. XXV, XIV)

Futures & Options

VIX futures offer a pure play on implied volatility. In fact, the ETNs/ETFs above use VIX futures to create their desired tracking portfolio.

Its options allow you to speculate on the index using puts and calls. However, these options on volatility are tricky. This is because their pricing involves the volatility of volatility.

What are the trading strategies for the VIX?

Hedging Against the Stock Market

The most common reason for trading the VIX is to hedge against market crashes. As the volatility index is inversely related to the stock market most of the time, it offers a good hedge.

To hedge against your stock holdings, buy out-of-the-money VIX call options.

If the market crashes, ideally, the options will gain value. The profit will then offset your losses in the stock market. If the market does not crash, the options will expire worthlessly. As out-of-the-money options are inexpensive, this strategy provides cheap and effective insurance.

The options offer an imperfect hedge, so losses are still possible. Also, if the spike in the index is drastic, it is possible to end up with a net profit despite the hedge. Of course, the outcome depends on your hedge ratio. The Options Guide has a detailed article on hedging with VIX options.

Timing the Market

You want to be greedy when others are fearful.

How do you know when others are fearful? Use the Fear Index.

When it rises to an extreme high, you get a potential signal of a market bottom. There is no guarantee of course, but high VIX levels always deserve a closer look.

More Trading Ideas for the Fear Index

VIX – A Useful Sentiment Indicator

At market extremes, emotions, and not fundamentals, drive the market. Hence, it is useful for traders to quantify emotions/sentiments.

The VIX belongs to an array of sentiment indicators. Other indicators include the put-call ratio and the NYSE Bullish Percent Index.

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Market Extra

Chart of Wall Street’s ‘fear’ index in 2020 illustrates how unhinged stock markets have been over coronavirus compared to the 2008 crisis

Mark DeCambre

The Cboe VIX boasted a nearly 300% year-to-date return at its peak on Tuesday

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Referenced Symbols

How volatile and anxious is Wall Street amid this evolving worry about a potential global pandemic that could shake the global economy to its core?

Perhaps, the best gauge of that deep-rooted concern is one of the market’s most closely watched measures of volatility.

The Cboe Volatility Index VIX, -8.07% , or VIX, hit its highest intraday level since 2008 on Monday, amid a stock market slump that also registered as the ugliest one-day plunge for the Dow Jones Industrial Average DJIA, -1.68% , the S&P 500 index SPX, -1.51% an the Nasdaq Composite Index COMP, -1.52% in 12 years.

But what’s arguably more impressive than the daily move for the gauge, that uses S&P 500 options to measure trader expectations for volatility in the coming 30-day period, is its year-to-date surge so far (see attached chart).

Compared against the move for the VIX at the same point this year in 2008, the differential between the two is dizzying. The VIX so far this year is on pace for a 280% surge, compared against a 108% return for the fear index in 2008—a period marked by the global proliferation of esoteric mortgage bonds and derivatives that brought world-wide financial markets to their knees and ushered in the 2007-09 recession.

“That spread is remarkable to see what’s going on out there in the [VIX],” Mark Longo CEO of The Options Insider, an options-focused analytics firm, told MarketWatch.

The rise in the VIX usually correlates to a decline in stocks because traders and investors use it to hedge their equity positions.

The surge in the VIX was at least partially sparked by an outbreak of COVID-19, the infectious disease that was first identified in Wuhan, China in December and has sickened roughly 117,000 people and claimed more than 4,260 lives, implying that fears of the deadly pathogen to this point by far outstrip those pegged to an implosion of the global financial markets.

That may have been the inflection point, the coronavirus,” Longo said.

Longo also said the surge in VIX this year may reflect that the markets, which have enjoyed a period of quiescence, even amid a few bursts higher, may be entering a paradigm shift.

“We may be in a new volatility regime for the foreseeable future,” he said.

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The options expert said it is worth noting that this period for the VIX is demonstrably different than 12 years ago because there are so many more products that are pegged to the VIX, including the VelocityShares VIX Short Term ETN VIIX, -4.49% , the iPath Series B S&P 500 VIX Mid-Term Futures ETN VXZ, -1.40% , and iPath S&P 500 Dynamic VIX ETN XVZ, -0.74% among a few.

Randy Warren, chief investment officer at Warren Financial, who focuses on VIX options, also said that on a year-to-date basis the peak for 2008 didn’t start to play out until August, September, and October as Fannie Mae and Freddie Mac went into conservatorship, Lehman Brothers went bankrupt, AIG required help from the government and investors wrestled with the fallout of all that. The VIX finished the full year 2008 up 130%, according to FactSet data.

The VIX hit a historical peak at 80.86 on Nov. 20, 2008 and had not again approached such a lofty level until Monday.

That said, Warren says his firm has made 10x its money on its VIX contract bets this year, but that those gains have only mitigated losses on its equity positions.

As far as where VIX is headed, Warren says it is anyone’s guess.

“It’s a really hard call at this point because [the VIX], it is really stretched. It’s like a rubber-band now,” he said, given its move from a recent low at around 13 or 14 in mid February. The VIX’s historical average usually is said to be about 19 or 20.

Longo emphasized that he thinks professionals use VIX futures to better measure volatility in the market rather than the so-called cash VIX, which is most commonly used.

He said the spread between the VIX and VIX contracts, the VIX is an index and the contracts are the tradable securities, have been stunning with unusual gaps of 12 points at some junctures in the market.

It isn’t clear to those traders what’s underpinning those odd moves. “I’ve never really seen it like that before–they are somewhat disassociated from futures. They should be in lockstep,” Longo said.

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