Strategies to Trade Volatility Effectively With VIX

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Strategies to Trade Volatility Effectively With VIX

The Chicago Board Options Exchange Market Volatility Index, or VIX, provides traders and investors with a bird’s eye perspective of real-time greed and fear levels, as well as a snapshot of the market’s volatility predictions over the following 30 trading days. The CBOE launched the VIX in 1993, enlarged its definition ten years later, and added a futures contract in 2004.

Volatility-based securities, which were launched in 2009 and 2011, have proven tremendously popular with traders for both hedging and directional plays. As a result, the buying and selling of these instruments has had a substantial influence on the original index’s functioning, which has been turned from a lagging to a leading indicator.

Convergence-Divergence Relationships

Active traders should always have a real-time VIX on their market screens, comparing the indicator’s movement to price action on the most popular index futures contracts. These instruments’ convergence-divergence connections produce a set of expectations that aid in trade planning and risk management. Among these expectations are:

  • Rising VIX + rising S&P500 and Nasdaq100 index futures = bearish divergence, indicating dwindling risk appetite and a strong likelihood of a downward reversal.
  • Rising VIX + dropping S&P500 and Nasdaq100 index futures Indicate negative convergence, increasing the likelihood of a downtrend day.
  • Falling VIX + falling S&P500 and Nasdaq100 index futures = bullish divergence, indicating increased risk appetite and a strong likelihood of an upward reversal.
  • Falling VIX + rising S&P500 and Nasdaq100 index futures Imply bullish convergence, increasing the chances of an upward trend day.
  • Divergence between the S&P 500 and Nasdaq 100 index futures reduces predictive reliability, resulting in whipsaws, confusion, and range-bound circumstances.
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Charting The VIX

The VIX daily chart resembles an ECG rather than a price display, with vertical spikes reflecting moments of elevated stress caused by economic, political, or environmental causes. When attempting to decipher these jagged patterns, it’s better to search for reversals around significant round numbers like 20, 30, or 40, as well as around past peaks. Keep an eye out for interactions between the indicator and the 50 and 200-day EMAs, which may function as support or resistance.

Image by Sabrina Jiang © Investopedia2020

In between frequent shocks, VIX settles into slow-moving but predictable trend activity, with price levels gradually going up or dropping down. These transitions are easily seen on a monthly VIX chart showing the 20-month SMA without price. Take note of how the moving average peaked at 33 during the 2008-09 bad market, despite the indicator reaching 90. While these long-term patterns will not help with short-term trade preparation, they will be very valuable in market timing tactics, particularly in positions lasting at least 6 to 12 months.

Image by Sabrina Jiang © Investopedia2020

Short-term traders may reduce VIX noise and enhance intraday understanding by layering a 10-bar SMA on top of the 15-minute indication. Take note of how the moving average grinds up and down in a smooth wave pattern, which decreases the likelihood of erroneous signals. When the moving average changes direction, it is crucial to rethink positioning since it predicts reversals as well as the conclusion of price movements in both directions. When the price line goes above or below the moving average, it may also be utilized as a trigger mechanism.

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Trading Instruments

VIX futures provide the most direct exposure to the indicator’s ups and downs, although equity derivatives have gained popularity among retail traders in recent years. These ETPs use complicated computations that blend many months of VIX futures into short and mid-term forecasts. Among the major volatility funds are:

  • S&P 500 VIX Short-Term Futures ETN iPath Series B (VXX)
  • S&P 500 VIX Mid-Term Futures ETN iPath Series B (VXZ)
  • ETF ProShares VIX Short-Term Futures (VIXY)
  • ETF ProShares VIX Mid-Term Futures (VIXM)

Because of a structural bias that compels a regular reset to decreasing futures premiums, trading these instruments for short-term returns may be an unpleasant process. In stormy markets, this contango may wipe out gains, leading the security to significantly underperform the underlying indication. As a consequence, these products are best used as a hedging tool in longer-term strategies, or in conjunction with protective options plays.

Bottom Line

The VIX indicator, which was developed in the 1990s, has spawned a plethora of derivative products that enable traders and investors to manage risk caused by volatile market circumstances.

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