Traders will often refer to the VIX when things get choppy on the market. You’ve no doubt heard of the VIX Index if you follow the stock market on a regular basis. The real name for the VIX is the CBOE Volatility Index and VIX is the ticker symbol. You can trade the VIX under that symbol and track it through the CBOE Index.
The VIX Index is often called the fear gauge by traders. While it doesn’t specifically measure fear, the VIX measures the potential for volatility over the next 30 days. When there is volatility in the markets there is often fear. This article will answer the question of what the VIX index is and why you need to know about it if you are a stock trader.
What is the VIX Index?
The VIX Index is used to measure volatility in the financial markets in the United States. The index was established in 1993 by the Chicago Board Options Exchange or CBOE after it was determined that Wall Street needed a way to accurately measure volatility. While the VIX is a real-time gauge, it measures the potential expectations for volatility so this index is a forward-looking mechanism.
You might be wondering how an index can measure something like volatility in the markets. There is a science to it! What the VIX does is it takes the price changes of near-term options contracts for the S&P 500 index. This calculation provides a reading of the potential for volatility over the next 30 days. A general rule of thumb: the higher the reading on the VIX index, the higher the fear.
What is Volatility in Trading?
When it comes to stock trading, volatility can be a good or bad thing depending on your style. On a volatile day in the markets, we usually think of a lot of red candles. For the VIX, volatility will spike when there are more price fluctuations in the value of the options contracts for the S&P 500. Since the S&P 500 is the benchmark index on Wall Street, a surge in contract fluctuations will usually cause the entire market to be more volatile.
What causes volatility in trading? It’s not just the fear of seeing red in the markets. Volatility can actually present itself in a number of different ways. It can be caused by anything from an economic event to a natural disaster to rising geopolitical tensions. We can almost think of the VIX as a newsfeed for traders. If the VIX suddenly spikes, there is likely something newsworthy that just happened.
What Does The VIX Reading Mean?
Now that you’ve checked the VIX Index, what does it mean? There is no limit to how high the VIX can go, although it hasn’t ever closed higher than 82.69 which was during the COVID-19 flash crash. There were likely more volatile days in the past but since the VIX was founded in 1993, we can only use trading days since it was established. If you want to know what each VIX reading means, here is a brief look at what the different levels are:
Low VIX Volatility (0-20)
This is the most common range for the VIX historically. A reading of 0-20 usually means that the markets are calm and stable. A low VIX reading means that it should be pretty smooth sailing over the next 30 days for the S&P 500 and the rest of the markets.
Moderate VIX Volatility (20-30)
A moderate VIX signal isn’t anything to worry about, but there is some fear starting to build. At this point, it is uncertainty rather than volatility or fear. Do not take this as meaning a crash is around the corner because a moderate VIX reading is far from that. Let’s just call it some doubt from traders and potential volatility in the future.
High Vix Volatility (30-40)
If you get a high VIX reading, there is definitely volatility in the market and probably a lot of fear. Historically, this range is the most volatile we see unless there is a sudden market crash. The markets are red and the selling pressure is building.
Extreme VIX Volatility (40+)
An Extreme VIX reading is very rare and usually only happens during market crashes. At this point, if a market crash hasn’t already happened it likely will. This also indicates that there is some global event that is sending the markets into a state of panic and most stocks will be deep in the red.
How to Use the VIX Index When Trading
The VIX is used by traders for many reasons. First and foremost, the VIX is a great tool to gauge market sentiment and the potential for future volatility. Experienced traders know exactly why this is important and how it can give you an edge while trading. While the VIX should not be taken as gospel, it can be a great addition to your trading arsenal. Here are some ways that the VIX can be used to enhance your trading experience.
1. Risk Management Tool
The VIX Is a great way to risk manage your portfolio and foresee any potential volatility on the horizon. If the VIX spikes or looks to be ready to break out, you can hedge your holdings and portfolio to shelter you from potential losses.
2. Option Value
You can also use the VIX to gauge the market value of options contracts for assets. A higher VIX reading will often cause options premiums to spike, which means trading options can get trickier. Those who sell options for premium enjoy increased volatility!
3. Market Sentiment and Analysis
Professional traders and institutions use the VIX on a daily basis to gauge market sentiment among retail traders. It also provides insight into how people are anticipating things like seasonality, earnings reports, and macroeconomic events. Even if you don’t use it to trade, keeping tabs on the VIX can help you get a feel for what type of market it is.
How to Trade the VIX
The most popular way to trade the VIX is with cash-settled options. This means that you do not ever get assigned shares of the VIX, the transaction is settled in cash within your brokerage account. This is similar to if you were to trade options on the S&P 500 (SPX) index.
You can also trade VIX-linked ETFs. These assets allow you to own shares but you are still not invested in the VIX itself. Funds like the ProShares VIX Short-Term Futures ETF trade and hold VIX futures contracts that provide traders with exposure to the VIX.
The Bottom Line: What is VIX Index?
The VIX Index is a curious tool and asset for traders to use. It tracks something that is not really quantifiable in the volatility of the markets. While you can’t own the VIX, you can trade it using options or ETFs. If you ask us, the VIX is an index that all traders should familiarize themselves with. It provides a gauge of market sentiment and can even let you know when market sentiment is about to turn.
Stay Savvy!