Using Moving Averages to Trade the VIX

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Using Moving Averages to Trade the VIX

The Cboe Volatility Index (VIX) estimates volatility expectations over the next 30 days, with put and call options activity underpinning its computations. Volatility measures how much a security’s price swings over time.

Volatility may be calculated as the difference between the price of an asset and a market index, such as the S&P 500. The more volatile the market, the higher the risk connected with the asset. Investors may identify trend shifts in equities markets by monitoring the VIX moving averages.

Key Takeaways

  • The Cboe Volatility Index (VIX) estimates volatility expectations over the next 30 days, with put and call options activity underpinning its computations.
  • The extent of a price shift in an asset, such as a stock or commodity, is represented by volatility.
  • The Cboe VIX reflects the market’s expectations for S&P 500 index price fluctuations in the near future (SPX).
  • The VIX is commonly referred to as the fear index since it measures the anticipation that volatility will grow or decline.
  • As a consequence, price movements in the S&P 500 and equities markets are inversely tied to VIX price changes.

Understanding Moving Averages and the VIX

The extent of a price shift in an asset, such as a stock or commodity, is represented by volatility. The VIX index measures the market’s expectations for short-term price movements in the S&P 500 index (SPX).The VIX index gauges the volatility of price fluctuations by utilizing the values of index options that expire in the near future. As a consequence, the VIX is a short-term forecast of volatility.

The Fear Index

Options contracts provide the holder the right to purchase (call option) or sell (put option) an underlying asset, such as a stock, securities, or index, at a predetermined price (strike price).Options have a premium or cost connected with them, and the holder is either debited or credited with that premium depending on whether the option is bought or sold. Each option contract has an end date (or expiry).

Volatility is a component of option contract price that is included in the premium. If the volatility of the underlying index, such as the SPX, is predicted to grow or decrease, so will the option premium. As a consequence, options premiums convey information about price fluctuations and potential volatility.

Because market prices may increase or fall in response to good or negative news, the VIX measures the anticipation that volatility will grow or decrease, which is why it’s also known as the fear index. In other words, if the market anticipates a high level of volatility from an exogenous event such as a recession, the VIX will rise.

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If the market anticipates calm and steady economic circumstances, the VIX will decline. As a consequence, price movements in the S&P 500 and equities markets are inversely tied to VIX price changes.

Moving Averages

A moving average (MA) is a graphical depiction of a stock’s or security’s historical closing prices over a specified number of days. The moving average is produced by taking the average or arithmetic mean of the period’s closing prices. A 20-day moving average, for example, comprises the closing prices for the previous 20 days for a stock or investment, while a 200-day moving average contains the closing prices for the previous 200 days.

Moving averages may assist investors detect a stock’s trend and whether the trend is rising or diminishing. Moving averages, on the other hand, are considered lagging indicators since they are based on prior prices.

A 200-day moving average, for example, will have a bigger lag than a ten-day moving average since it comprises older values. A short-term moving average, such as a 20-day moving average, is more sensitive to short-term price movements than the 200-day moving average. Investors may observe whether recent price swings (called price action) are confirming or contradicting the long-term trend by charting a stock’s short-term and long-term moving averages on a chart.

Investors carefully monitor certain moving averages to discern trend shifts. For example, a positive trend shift occurs when a stock’s 50-day moving average crosses above its 200-day moving average, indicating that the price is going upward (or uptrend).

When the 50-day moving average crosses below the 200-day moving average, it is considered a bearish indicator, indicating that prices are falling in a downtrend.

Trading the VIX

While the VIX focuses on the S&P 500, traders and hedgers may also look at the Nasdaq 100 through the Cboe Nasdaq Volatility Index (VXN) and the Dow Jones Industrial Average via the CBE DJIA Volatility Index (VXD).

Moving averages applied to VIX serve as the foundation for a wide range of buy and sell strategies in broad-based instruments such as the SPDR Trust (SPY), as well as volatility-based futures contracts and exchange traded funds such as:

  • Futures on the Cboe Volatility Index (VIX)
  • ETN for the S&P 500 VIX Short-Term Futures (VXX)
  • ETF for VIX Short-Term Futures (VIXY)
  • ETN for the S&P 500 VIX Mid-Term Futures (VXZ)
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However, it is preferable to apply technical analysis directly to the index, rather than using futures or funds calculations, since pricing in such instruments decays via roll yield and contango, which indicate timing differences between future and current prices. Rolling futures contracts may help traders avoid this decline, but funds follow continuous charts, making them unsuitable for holding durations longer than a few days.

Traders use long- and short-term VIX charts to assess volatility patterns, seeking for supportive equities, options, and futures exposure. As the VIX rises, so does the connection between stock indices and their underlying components, making index funds more appealing than individual equities. As the VIX falls, this equation is reversed, promoting a stock picker’s market in which individual equities provide greater trading possibilities than index funds.

VIX Daily Moving Average

Moving averages used to the daily and weekly VIX track long-term changes in market sentiment as well as shock events that cause vertical surges out of basing patterns. These spikes in anxiety, whether caused by destabilizing economic data, natural catastrophes, or external events, may have a deleterious influence on investor psychology. As a consequence, emotional selling pressure might be generated, leading equities markets to plummet significantly.

On the daily VIX chart, the 50- and 200-day simple moving averages complement each other effectively. To review, the VIX has a negative correlation with equities markets. Crossing moving averages might indicate substantial psychological upheavals. Typically, the VIX 50-day moving average crossing below its 200-day moving average indicates better sentiment (higher stock prices), whereas the 50-day moving average crossing above the 200-day moving average indicates deterioration (lower equity prices).

In August 2020, for example, the VIX 50-day moving average fell below the 200-day moving average. Despite some market turbulence in the days that followed, the S&P 500 rallied. Crosses are common as a result of spikes and subsequent recoveries, enabling the astute technician to gauge the transition between mounting dread and a return to complacency.

The VIX 50-day moving average deviated downward from its 200-day moving average after the surges in September and late October 2020 faded. As a consequence, the S&P 500 rose from about 3400 in August to over 3700 at the end of the year.

Also, we can observe that as the VIX price goes near its 200-day moving average, volatility decreases and the index trades sideways; similarly, the S&P 500 trades in a similar manner. However, after the VIX price passes its 200-day moving average, the S&P 500 follows suit.

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The momentum behind the VIX move influences the S&P 500’s reaction and may decide the amount of the stock move. If the VIX is wandering about its 200-day moving average with no direction, it is unlikely to cause a significant move in markets.

VIX Weekly Moving Average

The weekly VIX chart illustrates long-term changes in emotion, such as the move from bull to bear markets. The link between the VIX and the 200-week moving average is particularly useful for detecting trends.

The VIX soared in October and November of 2018, pushing the VIX 50-week moving average over the 200-week moving average. The negative link between the VIX and the S&P was on show when stocks fell from about 2900 to just below 2450 in the last three months of 2018.

Fear gripped the markets in early 2020, as the coronavirus pandemic started, and the VIX spiked further, reaching far over 80 by mid-March 2020. As a consequence, the S&P 500 fell from about 3300 to 2200 (more than 30%) in little over a month.

The S&P 500 steadily rose as the VIX fell from late March to June 2020, exceeding the S&P’s pre-pandemic peak by August 2020. The 50-day moving average for the VIX also went over the 200-day moving average in March of 2020. Despite the VIX decreasing from its highs, the moving averages trailed behind the S&P 500’s comeback bounce in the ensuing months.

In other words, long-term charts, such as the weekly chart, will lag behind turbulent markets in the near term, which is why it’s critical to monitor VIX price movements and analyze charts using several time frames.

The Bottom Line

Moving averages smooth out the inherent choppiness of the Cboe S&P Volatility Index (VIX), giving short-term traders and long-term market timers access to extremely dependable sentiment and volatility data.

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