The VIX Essential Tutorial – S&P500 Implied Volatility Index


The VIX Essential Tutorial cover

When The VIX (CBOE Volatility Index) estimates the implied volatility of the options (put and call) on the S&P 500.

It expresses the volatility waiting by the operators about the main stock index in the USA.

Today the VIX measures the implied volatility in options, both call that put on the S&P 500 index.

 

The higher the VIX, the greater will be the perception of risk present on the market.

In financial jargon, the benchmark has earned the nickname “index of fear.”

 

History and evolution

Technical analysts used the VIX to highlight any stress situations present in equity markets.

Originally the VIX index represented the implied volatility of a hypothetical option at-the-money on the S&P100, with 30 Days to maturity.

 

Since it has changed 2003, the method of calculation with the Vix, which now measures the implied volatility in the short term (30 days) of a series of theoretical options on the S&P500 index listed on CBOE.

 

First, the Vix (implied volatility Index) is based on the implied volatility calculated on the options market, which differs from the historical volatility used by typical technical oscillators.

The implied volatility is one of the decisive factors in the pricing of the options.

For this reason, most of this variable is high. The greater will be the prize of the option, in the larger will be the possibility to gain.

 

We can define the implied volatility as the standard deviation to x days of past performance.

The options have an “implied volatility” that expresses the future expectations about future movements in the price of the underlying.

 

If operators expect higher volatility, it increases the prize that the buyer must pay to buy or sell the underlying at a price predetermined today.

The historical volatility and the implied are therefore different, since the first represents the variation of past performance, while the second expresses the expectation of price variation.

 

The implied volatility is a prediction about the future prices that have nothing to do with the current ones.

Even if the investors shall take into consideration the implied volatility in their investment decisions, causing a direct impact of this on the level of prices of today, there is no guarantee that the expectations about future prices will materialize.

 

Index of fear

VIX is called the “Index of fear” as a measure of the expectations about the future volatility of the S&P 500 index.

However, volatility increases so importantly, especially during the down ride phases of the market.

 

The operators of the financial markets will observe the VIX paying attention in particular to the threshold of the 25-30 points.

This is traditionally the critical threshold demarcating a condition of low volatility from a scenario of high volatility,  which is generally associated with a decline in equity markets.

 

We can, therefore, define the VIX as an indicator to measure the status of fear or the serenity of operators indirectly.

The relation regarding the underlying is inverse: in particular, a high value of Vix is achieved because they occur of panic selling, and the general sentiment is fear.

 

However, the index of “fear” not describes the fear of a decline in the bags.

The volatility described by VIX is to be understood in both directions, hence also to rise.

 

 

How to read the VIX

During periods of considerable uncertainty, fear of a sharp drop in the level of prices stimulates the demand for put options, useful to cover themselves from any falls by blocking the sale price.

From here leads to an increase of their implied volatility and, therefore, the value of the index VIX.

 

During the periods of a bullish market, there is more trust between operators, which less need to cover themselves from the collapse of the stock exchanges.

In these stages, the VIX stagnates on lower levels at 20.

 

We often use the VIX in optical contrarian, i.e., it tries to identify the extreme thresholds, the attainment of which provides the opportunity to build the strategies of reversal.

It exploits in this way one characteristic of the volatility, which is its mean reversion, i.e., the return of values toward a reference average.

 

More indicator approaches to extreme levels, the higher the probability of mean reversion, i.e., return toward the average values.

In particular, it records the extreme values of the Vix in correspondence of important minimum stock market USA.

 

The effectiveness of this indicator is not equally valid at shallow values, which does not always identify the significant maximum on the stock market.

 

The VIX Essential Tutorial

 

Trading Signals with Vix

Open short positions on the VIX when this reaches high peaks, with movements quick and very far from the historical average long period.

Open long positions on the Vix after it dropped on the meaningful minimum, climbs with a specific decision.

 

We base these strategies on the inverse correlation between the Vix and the stock market.

You can attend a significant difference in the behavior of the Vix during the phases of explosive ascent and descent characterized by panic selling.

 

From a statistical point of view, it was found that faced with the progress of market share higher than 5%, the Vix has left on the ground the same value, while during the sell-off heavier gauge of sentiment rose double regarding the loss recorded by the market.

This information is handy in optical hedging: in case of a bearish view, in fact, rather than open short positions on the index below, you can buy the future directly on Vix, with the additional advantage that the latter.

 

Trading with the VIX 

We can trade the VIX index via futures traded on CBOE.

Futures on the VIX have monthly deadlines.

 

Futures on the VIX can be:

Short-term (1 month): have the advantage to be more reactive to the spike of volatility, but the roll-over is more expensive (because of the effect contango).

Medium-term (6 months): are less reactive to spike volatility, with a roll-over less expensive but have reduced liquidity.

 

The quotations of Vix (below) and VIX futures approach as they come closer to the expiry of the future itself, but during the life of the future, the latter can have values higher or lower regarding the index Vix.

Under “normal” conditions, with stable markets or uphill with low volatility, the future share to values higher than the index Vix, while when the volatility increases, the opposite happens.

 

In the same way, the future with different maturity has different prices.

When the implied volatility is low and the index Vix has low values, the future expiry furthest quote on higher values regarding the future with the earliest maturity.

This situation is called contango. When the future expiry furthest shares to lower values regarding the future with the earliest maturity, it speaks instead of backwardation. It is the situation that occurs when there is volatility in the stock market.

 

Vixcentral.com

On the site, you Vixcentral.com can derive the structure of prices of various futures and observe from day-to-day if you are in a situation of contango or backwardation.

In the last’s course, 15 years, the price structure of the future was in contango for approximately 90% of the time and in backwardation “only” 10% of the time.

 

It is essential to highlight that the price of VIX futures expresses market expectations regarding “the value of the VIX index to the expiry of the future.”

Therefore, the evolution of the “price of VIX futures” is not identical to the growth of the “value of Vix Index current.”

 

The Ratio VXV/VIX

The ratio Vxv/Vix, a first strategy, is based on the use of the index Vxv, which is the index of volatility on the options to 3 months with an underlying the S&P500 index.

You build the relationship between the Vxv and Vix that, in normal conditions, sees the value of the first upper per second.

 

From its course you can highlight that:

When the ratio is greater than 1, it means that the volatility at three months is higher than the volatility in one month. When the rate falls, it means that there is volatility on the stock market, the energy declared by the volatility of the short term that rises quickly.

 

The ratio S&P500/Vix 

To highlight the sentiment present on the market, we can build a relationship between the S&P500 index and the Vix.

The result is a line that can highlight situations of optimism and pessimism, panic selling, and complacency. This is not a ratio that has the values of overbought/oversold preset but can provide a framework for the general climate present on the market.

The VIX and the Bands Bollinger

A second operational strategy provides for the computation of the Bands Bollinger on index Vix, taking as a basis the moving average 20 days.

The signs that derive from this are:

If the volatility moves downward and moves under the moving average of 20 sessions, it confirmed the soundness of the bullish trend present on the stock market.

When instead the volatility is maintained above the moving average, it is declared a problematic situation.

When the Vix goes beyond the upper band, highlights a situation of pessimism, while when the Vix drops below the lower band, it highlights a case of optimism.

These indications must, however, be used in an optical otherwise:

If the indicator goes on a minimum long period and heads the lower band Bollinger, it provides an excellent opportunity to go short on the market because it is legitimate to expect a correction of the market and a corresponding increase in the volatility toward the average value.

When the Vix goes beyond the 30 points and heads the upper band Bollinger, there is the possibility to go to rising on the market given that the volatility is excessive, and it is reasonable to expect a technical rebound associated with a return of the Vix toward the average value.

But when the volatility tears to rise and goes well above the upper band, it is provided a dangerous alarm bell, often associated with a sudden bearish wave on the market.

 

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External sources: Wikipedia

 

 

 

 

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