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Volatility Index (VIX) - CBOE Volatility Index Definition

Discover what the VIX volatility index is, how it works and how you can trade it in our guide to the popular measure of volatility.

CBOE Volatility Index (VIX) Definition & Strategy

The VIX index is a popular measure of market volatility. It provides opportunities for trading, with some traders using it to diversify their portfolio or others as an effective hedging tool. To understand how the VIX volatility index works, and how to trade on it, keep reading.

What is the VIX volatility index and how does it work?

In this article, you can discover what the VIX volatility index is and how it works. Following this, we will look at how you can trade the VIX volatility index and key considerations when doing so.

What is the VIX index?

The VIX volatility index (VIX^) is an indicator of stock market expectations of 30-day future market volatility. The CBOE created this product. Index values are derived from S&P 500 option price inputs and therefore represent expectations of market volatility and risk.

The VIX Volatility Index is known by other terms such as "Fear Gauge" or "Fear Index". For investors, the VIX index is a good way to judge market risk, fear and uncertainty when making trading decisions in a volatile market.

How does the VIX volatility index work?

CBOE’s volatility index was designed to measure the market’s expectations of market volatility; it achieves this by using option prices from the S&P 500. By judging how far the put and call prices are distributed from the current price of the S&P 500, the volatility index draws an average, which is represented by VIX’s current price.

The VIX volatility index is based on option prices from the Standard and Poor's 500 Index. The calculations indicate that the market is likely to be volatile in the next 30 days.

Although VIX cannot be traded directly, many traders use ETFs or ETNs tied to VIX to gain exposure to VIX. Additionally, many investors take the VIX as a useful opinion of market volatility outside of trading it.Volatility indexes are often based on this currency.

Analysing the VIX volatility index during COVID-19

The VIX index fluctuated to levels not seen since the 2008 financial crisis during the coronavirus crisis. This led to several ETFs and ETNs that track the VIX index jumping wildly in price. Some of these indexes were used to magnify fluctuations, creating more risk for profits and losses.

In March 2020, the VIX index, which tracks the 30-day implied volatility of the S&P 500, rose above $82, a new record that exceeded the $80.86 reached in late 2008. After the index dipped, it reached a level of 56.14 one month later.

Despite the recent dip, the S&P 500 has generated many opportunities during the coronavirus pandemic. The iPath S&P 500 VIX Short-Term Futures ETN [VXX] rose by 391% from the 20th of February to the 18th March, before dropping again.

For those interested in volatility trading with a higher appetite for risk and who want even greater exposure to the index, the ProShares Ultra VIX Short-Term Futures [UVXY] grew by more than 880% over the same three-week period. This ETF provides leveraged exposure to the S&P 500 VIX Short-Term Futures Index.

Furthermore, since the start of the year, the VelocityShares Daily 2x VIX Short-Term ETN [TVIX] — which provides a two-times leveraged exposure to an index comprised of first- and second-month VIX futures positions — has climbed 664% since the start of the year, according to Reuters, peaking at the 806 level on the 18th March, up 1712% YTD at that point.

Trading the VIX volatility index

Although the VIX index cannot be directly traded on, several indexes track the VIX index and can be traded on. A popular ETF that provides exposure to the S&P 500 VIX Short-Term Futures Index can be accessed through the NG platform, the ProShares VIX Short-Term Futures ETF. This index measures the returns of a portfolio of monthly VIX futures contracts with a weighted average of one month to expiration.

ETFs tracking the S&P 500's volatility, such as the ProShares VIX Short-Term Futures, are designed for advanced investors. This volatility is measured by the prices of VIX futures contracts.

The ProShares VIX Short-Term Futures ETF can serve as an effective hedge against the S&P 500 when used for short-term leveraged trading

How to trade on the VIX index

  • Do your research on the asset you have chosen. Using your market research, determine which direction to trade in, where to enter the market, and the size of your position.
  • Consider risk management. Having a plan when trading can reduce the likelihood of making irrational decisions. Also, you can mitigate the risks associated with trading by using stop-loss and take-profit orders.
  • Place you VIX index trade. Open an order ticket and fill out the appropriate fields. Place your trade and monitor its performance. Do not forget to close your position once you are satisfied with the results.

Key considerations when trading the VIX volatility index

  • ETF traders should be careful when using leverage. It is important to note that leveraged ETFs are complex financial instruments that carry significant risks, and certain leveraged ETFs are only appropriate for experienced traders.
  • Manage your risk. When leveraged trading you can make substantial profit but can also make large losses. You can automate parts of your trading and manage your risk exposure with the use stop-loss and take-profit orders.
  • Don't stop researching. When trading markets, you can gain a great deal of advantage by understanding how assets work and what influences them. In this case, the more you know, the better.

Key takeaways

When market fear is high, so is the price of the VIX index. Whereas, a lower VIX can be a sign of either greed or investor complacency. Using the VIX alongside other measures of volatility and market outlook can help to provide crucial clues into current investor sentiment and an indexes outlook.

Finally, the VIX volatility index is just a single model of volatility. You can reduce risk exposure by combining multiple inputs and models in your trading compared to betting on one variable alone.

Source: CMC Markets UK

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