The Vix index is an indicator of the implied volatility of options on the S&P 500, the representative index of the American stock market. In short, it is calculated in real time by the Chicago Board Options Exchange (CBOE). VIX is expressed as a percentage. Its increase indicates that there is tension in the markets. Conversely, a decline in the index implies a phase of relative calm.
It is not possible to back test the index. In fact, it only shows the implied volatility of the US stock market over the next 30 days.
Although the VIX is related to the S&P 500 index, it is a benchmark for the entire global stock market. Since the demand for options is very high in times of stress, the higher demand for derivatives brings with it an increase in implied volatility.
This also causes our indicator to grow which, not surprisingly, is commonly known as the index of fear due to its surges in the vicinity of particularly traumatic events for the markets.
How VIX works
The index tracks the implied volatility of options on the US stock index. Knowing a little better how the underlying works is useful for understanding and using the VIX for practical purposes. In particular, options are standardized derivative contracts which give the right, but not the obligation, to buy or sell an index or financial instrument and/or within a certain deadline. In our case, the underlying is the US S&P 500 stock index.
A call option gives the right, upon payment of a price called the premium, to buy the S&P 500 at a predefined price, called the strike. Conversely, a put option will give the right to sell the same underlying at a fixed price.
How is the VIX index calculated?
The calculation of the index is quite complex. It starts from the S&P 500 options expiring on the third Friday of the month and from the weekly options expiring every Friday. Then a complicated mathematical calculation is done which, in the end, returns a number as a percentage. To be included in the VIX index, an option must have an expiration date between 23 and 37 days.
Understand the values of the VIX
There is an inverse correlation between the trend of the fear index and the stock market. In fact, a surge in the former often precedes a decline in the latter.
What happens when the VIX rises?
A rise in the indicator implies phases of tension on the markets, with possible downturns on the horizon. Abnormal surges occurred during the Great Crisis of 2007-2008 and, more recently, with the global COVID-19 pandemic.
What happens when the VIX is down?
When the indicator goes down the traders are relaxed. There is less tension on the market and it is reasonable to hypothesize a rise in prices.
A useful point of reference is the 20-30 range. Below 20 we are in a phase of relative tranquility; on the contrary, a climb above 30 requires some attention, as the market is entering a fibrillation phase.
A curious phenomenon concerning the VIX is the tendency of the index to turn suddenly. In short, it converges towards its historical average. This means that periods of low volatility are followed by others in which it soars and vice versa. When volatility is high, it’s a good time to buy. When, on the other hand, the VIX is “crushed” to the lows, an external event could upset the markets.
For these reasons the motto is valid: “buy when the index rises and sell when the VIX falls”. It is, of course, a custom and not an iron law.
Trading the VIX
Why trade the VIX? The reasons are essentially two:
· speculate in the short term
· diversify your financial portfolio thanks to a product negatively correlated with shares.
For example, those who have invested in the US stock market and fear a drop in prices in the short term will be able to buy the volatility index in the ways we will see. In this case, if the market goes down, the losses can be compensated, in whole or in part, by the appreciation of the VIX, if this is accompanied by rising volatility.
The tools to use
CFDs
CFDs, or contracts for difference, allow you to earn on the change in the price of the index between the date of opening and closing a position. Capital gains are taxed at 26%; however, they can be compensated with previous minuses.
Barriers
These are contracts that replicate the underlying precisely, without leverage. They close automatically if the price of the underlying market reaches your chosen level, also known as the knock-out level, thus limiting your risk. However, these are very speculative instruments that the investor will do well to avoid.
Bullish speculation (long)
Who goes “long” on an underlying bet on the revaluation of the same. In particular, anyone who opens a long position on the VIX is a person who fears a sudden increase in volatility, with a consequent decline in the market.
In summary it can be:
a trader who wants to speculate in the event of a spike in volatility
an investor who wants to protect his capital from possible declines.
Bearish speculation (short)
Going short on the VIX means betting in a calm phase of the markets. A “shockless” climb of the S&P 500, in fact, would compress volatility and with it the fear index.
Market reactions and extreme values of the VIX index
The outbreak of the conflict between Russia and Ukraine has pushed up the fear index. It has reached the level of 32. This is a level far above the average of 19 points recorded since 1990 and the value of 17 points at the beginning of the year. Anyone who thinks of selling in turbulent market phases, however, risks making costly mistakes.
In fact, the S&P 500 generated an average 12-month return of more than 15% when the VIX hovered between 28.7 and 33.5 points and more than 26% when it exceeded 33.5 points. This suggests a rule of thumb for the knowledgeable investor: take advantage of moments of volatility to enter the market.
On March 17, 2020, the index reached an all-time high at 82.69 points. It had previously reached 80 during the subprime mortgage crisis in November 2008.
