Use VIX to effectively trade volatility strategies

The CBOE Market Volatility Index, better known as VIX, provides traders and investors with a real-time bird’s-eye view of the level of greed and fear, as well as a snapshot of the market’s expectations of volatility over the next 30 trading days. The Chicago Board Options Exchange launched VIX in 1993, expanded its definition 10 years later, and added futures contracts in 2004.

Facts have proved that the volatility-based securities launched in 2009 and 2011 are very popular in the trading world, whether it is hedging or targeted trading. In turn, the buying and selling of these instruments has had a significant impact on the operation of the original index, which has transformed from a lagging indicator to a leading indicator.

Convergence-divergence relationship

Active traders should always maintain a real-time VIX on their market screen, comparing the trend of the indicator with the price trend of the most popular index futures contracts. The convergence-divergence relationship between these tools produces a series of expectations that are helpful for trading planning and risk management. These expectations include:

  • VIX rise + S&P 500 index and Nasdaq 100 index futures rise = bearish divergence, indicating a high risk of shrinking risk appetite and a downward reversal.
  • VIX rise + S&P 500 and Nasdaq 100 index futures fall = bearish convergence, increasing the likelihood of a downtrend day
  • Falling VIX + falling S&P 500 and Nasdaq 100 index futures = bullish divergence, indicating that risk appetite will grow and the upward reversal is highly likely.
  • VIX fall + S&P 500 index and Nasdaq 100 index futures rise = bullish convergence, increasing the possibility of an uptrend day.
  • The different behaviors between the S&P 500 Index and the Nasdaq 100 Index futures reduce the reliability of forecasts, often resulting in shuffles, confusion, and range fluctuations.
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Plotting the volatility index

The daily VIX chart looks more like an electrocardiogram rather than a price display. It produces vertical spikes that reflect periods of high stress, caused by economic, political, or environmental catalysts. When trying to explain these jagged patterns, it’s best to observe the absolute level and look for the surrounding Reverse large integers, such as 20, 30, or 40, and get closer to the previous peak. Also pay attention to the interaction between the indicator and the 50-day and 200-day EMA, these levels act as support or resistance.

VIX enters a slow-moving but predictable trend behavior between cyclical stress factors, and the price level slowly rises or falls over time. You can clearly see these shifts on the monthly VIX chart showing the 20-month SMA without price. Note how the moving average peaked around 33 during the 2008-09 bear market, even though the indicator has risen to 90. Although these long-term trends do not help short-term trade preparation, they are very useful in market timing strategies, especially for positions lasting at least 6 to 12 months.

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Short-term traders can reduce the VIX noise level and improve intraday interpretation by using 10 moving averages above the 15-minute indicator. Note how the moving average gradually rises and falls in a smooth wave pattern, thereby reducing the chance of false signals. When the moving average changes direction, it is time to re-evaluate the position, because it heralds the completion of a reversal and price fluctuations in both directions. It can also be used as a trigger mechanism when the price line crosses above or below the moving average.

Trading tools

VIX futures provide the purest exposure to the rise and fall of indicators, but in recent years, stock derivatives have gained a strong following among retail traders. These exchange-traded products (ETP) use complex calculations to layer multiple months of VIX futures into short-term and medium-term expectations. Major volatility funds include:

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  • Standard & Poor’s 500 VIX Short Term Futures ETN (VXX)
  • Standard & Poor’s 500 VIX Interim Futures ETN (VXZ)
  • VIX Short-term Futures ETF (VIXY)
  • VIX Interim Futures ETF (VIXM)

Trading these securities for short-term profits can be a frustrating experience because they contain structural biases that force the declining futures premiums to be constantly reset. Such futures premiums may wipe out profits in volatile markets, causing securities to perform significantly below the underlying indicators. Therefore, these tools are most suitable for use as hedging tools in long-term strategies, or in combination with protective options.

Bottom line

The VIX indicator created in the 1990s gave birth to a variety of derivatives, enabling traders and investors to manage risks caused by stressful market conditions.


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