Most traders are just trying to stay ahead of the curve.
Some scour through the latest financial news and company reports to glean insight into the future of a stock or sector.
Others use technical indicators to determine chart patterns and key price levels.
Whatever methods they use, the goal remains the same – to figure out where a stock (or index) is heading and capture some of that move.
I like to use something that gives me an even bigger picture of what might lie ahead – the CBOE Volatility Index (VIX). It’s often referred to as the “fear index.”
The VIX often indicates when the market is heading for a fall.
While most forms of analysis focus on past trends (like historical information and prices), the VIX is forward-looking. It gauges what traders are expecting the market to do in the next 30 days.
The distinction comes from how it’s constructed…
The VIX measures the volatility of the S&P 500 using index options. The higher the VIX is, the higher the expected volatility will be over the coming month.
Let me break down how that works…
When traders think the market will rise, they buy call options. And when traders are nervous about a potential fall, they buy put options.
The more nervous they become, the more they’ll pay for those put options. That’s what sends the VIX higher.
But just because traders are nervous and buying put options doesn’t always mean the market will fall – though it can often become self-fulfilling.
That’s because if those same traders are expecting a fall, they’ll also be selling out of their long positions. That can add to the wider selling momentum and send the broader market lower.
But even if you don’t trade options at all, the VIX is still useful.
To see what I mean, look at the chart below of the S&P 500 with the VIX below it…
S&P 500 (SPX) with CBOE Volatility Index (VIX)
Source: eSignal
The blue line represents the S&P 500 Index (SPX), and the red line is the CBOE Volatility Index (VIX). Let’s look at the relationship between the two…
You can see that when the VIX spiked back in March (meaning nervous traders), it coincided with SPX falling heavily.
Then as volatility (VIX) gradually fell from March to August, the SPX steadily rose.
Although they’re not an exact mirror of each other, there’s a clear (inverse) correlation between the two.
That applies to both larger and smaller moves.
Basically, when the VIX spikes, we can expect the S&P 500 index to fall. And for a trader, this type of information can be crucial.
If volatility is starting to rise, you may delay going long in a stock (or the index). Or if you’re looking to short a stock (or index), you might use a spike in volatility to help decide when to enter.
But traders closely watch for more than just the initial spike in the VIX…
Spikes in the VIX are typically short-lived. They usually don’t last more than a few days.
So what happens after the spike is also helpful to traders.
To see what I mean, check out the action from March through to August when SPX was rallying…
S&P 500 (SPX) with CBOE Volatility Index (VIX)
Source: eSignal
While the SPX initially fell when the VIX spiked, it went on to rally as the VIX dropped back into its normal range.
Some traders may use a spike in the VIX as a signal to go short.
But others who are bullish on the long-term market trend might see the VIX spike and use the pullback as a trigger to go long.
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That’s why the VIX can be a useful tool in either market direction.
Of course, the VIX might not work 100% of the time (nothing does in the markets).
But it can offer a much broader and deeper understanding of market movements…
And that can be beneficial in improving your trading success.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict
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Do you use the VIX with your trading? Let us know at [email protected].