Updated: Jul 6, 2021
Ever heard Investors or newsreaders talk about "market fear" or "volatility" and wondered how they know what they know?
Look no further than the Cboe Volatility Index, or VIX and more specifically this blog where we will go over all the essential details you need to understand how to read the VIX and market sentiment!
Our learning outcomes for this blog are...
What is the VIX?
How does the VIX work?
Why does Volatility matter?
Is a high VIX good or bad?
How to use the VIX in your trading strategy!
What does the VIX mean?
“The Cboe Volatility Index, or VIX, is a real-time market index representing the market's expectations for volatility over the coming 30 days. Investors use the VIX to measure the level of risk, fear, or stress in the market when making investment decisions.”
At logikfx we say that volatility is our friend
The VIX is a great tool to determine the volatility in the markets at the current moment, The more volatile the market is the more money there is to be made as the market moves over much larger distances, lower volatility means that there won’t be big changes in price meaning there will be much less opportunity to capture the same kind of profits in those moves.
How does the VIX work?
The VIX measures the volatility of the S&P 500 (SPX)…
When the VIX is up, it means that there are significant and rapid price fluctuations on the S&P 500. The VIX has a negative correlation with the S&P 500 meaning that it moves in the opposite direction to the S&P, so in periods of market stress, the VIX increases.
What is the S&P 500 (SPX)?
The S&P 500, or simply the S&P, is a stock market index that measures the stock performance of 500 large companies listed on stock exchanges in the United States. It is one of the most commonly followed equity indices.
Even though the VIX tracks only the SPX it is used as an indicator for the whole US stock market, the price of options is seen as the best way to gauge how many bigger investors and Professional Traders are feeling towards the market as when uncertainty hits the market traders and investors tend to buy options as a more secure asset.
Is a high VIX good or bad?
Whether high volatility is good or bad is down to you as the investor, trading with high volatility is very risky, especially when you are trying to trade short term and use high leverage...
This all depends on your mentality as a trader, to be a successful in the markets you have to be ready to take the right kind of risks.
When trading in periods of high volatility the risk is definitely higher, however, the higher the risk the higher the reward.
Its really down to the individual trader and their confidence in their abilities and more importantly their analysis, the more confident you are the more comfortable you will be trading in times of high volatility.
One way that you can do this is by emulating the professional strategies, using fundamental analysis and proper risk management, for more info on this read how you can become a successful trader! When the VIX is high you'll see the price of the S&P500 drop, it's not called the "fear gauge" for no reason! Therefore, as the S&P500 rises, investors feel happy, confident and prosperous about future stock market conditions but at the same time you'll see the VIX decline.
What is the current level of the VIX?
As you can see as of the 03/04/2021 the VIX is at a low level, this indicates that there is a lot of confidence in the stability of the market, below is an example of how the VIX shows the sentiment for the S&P 500...
As you can see over the same time period as the VIX creeps lower the S&P 500 also makes gains!
How does the VIX affect the Forex Market?
Just the same as how the VIX reflects on the S&P500 we can see that it has the same or similar affects on different currency pairs, As the XIV is a reflection of investors views on the US economy it makes sense that you could also see an affect on the US dollar...
The VIX shows the confidence on investors not only in different companies but also the economy itself, I mean no-one wants to invest in a poor economy, this relationship can be seen when looking at the VIX compared with GBP/USD
As you can see the same VIX chart as above is shown here...
And as you can see from the above chart GBPUSD has an direct correlation with the VIX level, you can see the clear dip in march at the start of the pandemic and then a gradual recovery.
Just to note that even though there is a correlation between the VIX and the USD similar to the VIX and the S&P 500, due to the fact that currency is influenced by a number of different factors The level of the VIX should only be art of a wider fundamental analysis!
What is the highest the VIX has ever been?
The highest level ever reached on the VIX was 89.53 on October 24, 2008, at about the in crest of the financial crisis. The all-time high on the VIX was reached on October 24, 2008 at 89.53 although it closed the day at only 79.13. – naic.org
Can you trade the VIX directly?
You can’t buy into the VIX directly as it is an indicator, however, there are a few ways that you can use the VIX to invest…
1. VIX futures – a futures contract is an agreement to deliver something at a certain point in the future for the current price. The first futures contracts were for commodities such as wheat and corn, and they're available for many commodities now, including oil and natural gas.
VIX futures do not involve the actual delivery of anything but when the contract reaches its end there is a cash delivery tied to the value of the VIX at the end of the contract, so if the price in lower than at the start of the contract you must pay the difference but if it is higher you have made a profit.
VIX futures are hard to find and are rarely offered by mainstream brokers, they are also extremely risky and hard to predict, so this type of VIX investing is only recommended for experienced traders.
2. Invest in the S&P 500 – the VIX tracks the volatility of the S&P, so one easy way to use the VIX to invest is using it as a good indicator as to when to invest based on your own risk appetite as we discussed earlier in the blog.
A high VIX reading marks periods of higher stock market volatility, while low readings mark periods of lower volatility. Generally speaking, when the VIX rises, the S&P 500 drops, which typically signals a good time to buy stocks.
3. VIX ETF’s - Investors interested in the VIX ETF space should consider investing for a short period of perhaps a day. Many of these products are highly liquid, offering excellent opportunities for speculation. VIX ETFs are highly risky, but when traded carefully, they can prove to be lucrative. – investopedia.
If you are confused as to what an ETF is, check out this blog we released explaining ETF’s and what to look for in a successful one!
The VIX is a very smart tool, it gives an insight into the mindset of traders around the world in real time, it allows us to asses how volatile the market is, it tells us what the general consensus of traders in the market is (are they confident or fearful?) and it allows us to make an informed decision on whether to trade/invest or to wait until a time when we are more comfortable in doing so.
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