What is VIX Index?
VIX is CBOE indicator that measures is the implied volatility that is being priced into S&P 500 index options. Through the use of a wide variety of option prices, the index offers an indication of 30-day implied volatility as priced by the S&P 500 index option market. VIX is considered a gauge of fear in the overall market
What is the implied volatility?
Implied volatility is ultimately determined by the price of option contracts. Since option prices are the result of market forces, or increased levels of buying or selling, implied volatility is determined by the market. An index based on implied volatility of option prices is displaying the market’s estimation of volatility of the underlying security in the future. The implied volatility of an option is also considered an indication of the risk associated with the underlying security. The risk may be thought of as how much movement may be expected from the underlying stock over the life of an option.
What is the relationship between the VIX index and SP500?
The VIX has historically had an inverse relationship with the S&P 500 index. The reason behind this inverse relationship relates to the type of option activity that occurs during bullish markets versus bearish markets. When markets rally, there is rarely a rush by investors to purchase call options. Therefore, when the market is rising, there is rarely dramatically higher option purchasing versus options selling. When the S&P 500 comes under pressure, especially in very turbulent times, there is often a panic-like demand for put options. This demand for protection results in increased purchasing of put options. The result is a fast move higher in implied volatility for both S&P 500 put and call options. This higher demand then results in an increase in implied volatility and finally a move higher in the VIX index. Figure (1) shows the relationship between SP500 and VIX Index
Figure 1
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How to use VIX index in trading SP500?
VIX index is a sentiment indicator that considered a gauge of fear in the overall market, so when VIX is rising that mean trader are panicking and dropping their shares and that is good time buy from them. When VIX Index moves above its Bollinger Band it is good time to buy SP500 expecting bounce up as shown in figure (2)
Figure 2
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Trading Nasdaq100 and Dow Jones 30 Using VIX Index
In addition to an index based on S&P 500 volatility, the CBOE has developed a handful of other volatility measures based on other common stock market indexes such as CBOE DJIA Volatility Index (VXD) and CBOE NADSAQ-100 Volatility Index (VXN) and both could be used like VIX Index. Figure (3) shows the relationship between the Nasdaq100 index and its volatility index (VXN) and Figure (4) shows the relationship between the Dow Jones 30 and its volatility index (VXD).
Figure 3
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Figure 4
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Larry Connors VIX RSI Trading System
Connors’ VIX RSI is a mean-reversion strategy, based on the concept of markets overreacting to news and reverting to their mean in the short term. The key idea of this strategy is to combine the RSI indicator with the VIX volatility index to identify rapid market sell-offs, and take a profit when they snap back
Strategy Rules
The operation of VIX RSI can be summarized as follows:
• trade an S&P 500.
• open position, if
• S&P 500 trades above its 200-day moving average
• 2-period RSI of VIX is above 90
• today's VIX open is greater than yesterday's close
• 2-period RSI of the S&P 500 is below 30
• exit position, if 2-period RSI of the S&P 500 closes above 65 as shown in figure (5)
Figure 5
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Hedging with VIX Derivatives
The VIX futures and index option markets have experienced tremendous volume growth over the past few years. This has come as a result of institutions accepting volatility as an asset class. Both of these instruments are used as hedges against a drop in stock prices. This use of VIX derivatives comes into play due to the inverse relationship between market implied volatility and the direction of stocks.
Why you should buy VIX futures when market is decline?
In times of market turbulence, the VIX index often rallies in a magnitude that is many times that of the drop of the S&P 500 index. An excellent example of this occurred during the market turbulence in 2008. Table 10.3 compares the performance of the VIX index and futures contracts to that of the S&P 500 index.
Figure 6
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Table 10.12 shows the return based on holding a portfolio that matches the performance of the S&P 500 index monthly from 2007 to 2010. This will be representative of a buy-and-hold portfolio. Table 10.13 is a return calculation based on holding a continuously rebalanced portfolio representing the next two expiring VIX futures contracts. Table 10.15 shows the result of $10,000 invested in the S&P 500 and compounded monthly. Table 10.16 shows the result of 90 percent of a portfolio invested in the S&P 500 and 10 percent of a portfolio with exposure to the balanced VIX future strategy.
Figure 7
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Figure 8
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Figure 9
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igure 10
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- All tables from book “Trading VIX Derivatives: Trading and Hedging Strategies Using VIX Futures, Options, and Exchange-Traded Notes” by Russell Rhoads
Conclusion
Warren Buffett once said that it is wise for investors to be “fearful when others are greedy, and greedy when others are fearful”. It is very useful advice and VIX indicator will be very useful to know when people is geedy and when are fearful so VIX indicator must be tool in every trader's arsenal.