Importance of the Volatility Index (VIX)
Introduction to VIX
The Volatility Index, VIX, is essentially a “fear gauge” for the expected market volatility based on the options traded in the S&P500. It’s important to seasoned investors because it helps predict the market sentiment—whether traders are feeling confident or fearful about the future, or even just the day. Similar to the fear-and-greed index, the VIX is an indispensable tool that every investor should check, even if you aren’t trading options.
The Basics
The VIX isn’t a traditional stock or security where you can buy and sell shares of it, even though it appears this way. However, it isn’t fully an index such as the S&P500 either, as it doesn’t track a sector of securities (simply the put/call ratio in the S&P500), moreover you can still trade naked options on it unlike most indexes. The Chicago Board Options Exchange (CBOE) uses prices of near term S&P options to calculate the VIX. Thus, the forecast of the VIX is of the volatility over the next 30 days, calculated day-by-day when the market is open.
Think of the VIX as a weather forecast for the stock market. When the VIX goes down, the day will most likely be smooth sailing with stability in the green, like a 72 degree, sunny day. If the VIX spikes up, that often signals rollercoaster days in the red, like an incoming Sharknado. Similar to the meteorologist, the VIX can be wrong; though, the VIX has a much better track record than my local meteorologist.
Why it Matters
For most long term investors, you may be thinking “why would I care about short-term volatility if I’m going to hold through it anyways?”. Because, volatility represents risk, yes, but also opportunity. During extremely high volatility, the VIX becomes a screaming “BUY” signal for investors. For example, during the 2008 crash, the VIX surged above 80, it’s currently at 16.66 for reference. Again during Covid, the VIX reached close to 60.
A wise man once said every action must have an equal-opposite reaction, and this is no different for the VIX signaling buy in a crisis: if you look at the lowest points in the VIX (i.e. the bull rallies of the past), like clockwork the VIX gradually creeps up before spiking when prices drop and the market pulls back.
How to Interpret the VIX
If you are completely foreign to the volatility index, this can be an overwhelming amount of information. Don’t fret, I will layout the markers in which long-term investors can understand where the market sentiment lies through different VIX prices.
Extremely Low VIX (Below 10): Major bull rally — markets are more than likely inflated, consider hedging positions
Low VIX (Below 15): Market calm — most likely steady growth, but prices are starting to be inflated
Moderate VIX (15-25): Normal market uncertainty — healthy fluctuations, would be considered ‘neutral’ on the fear-and-greed index
High VIX (Above 30): Fear is high — see as a buying opportunity, prices are low!
Keep in mind, the VIX doesn’t predict the up or down direction of the market, just the magnitude of the movement.
A Tool, Not a Crystal Ball
The VIX is a great index to keep your eye on, no matter what type of investor you may be. It’s what many call the “emotional barometer” of the stock market. There’s nothing concerning the statistics within a business in the VIX, only short-term trader emotion. While this may sound concerning to many, it creates opportunities for the few. As for myself, I’ve been perfecting a strategy for trading VIX options that have given me solid intraday returns (see below).
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