What the VIX Tells Us and How to Trade It

The CBOE Volatility Index, otherwise known as the VIX, is a volatility indicator that measures the expected volatility in the next 30 days. It's often called the 'fear index' by investors as it shows whether it's time to buy or sell stocks. Before I get more into it, let me just say that trading an index like the VIX is extremely risky and trade at your own risk.

What the VIX is Telling Us

Before the stock market crash in March, the VIX was trading under $20. When fears rose due to the pandemic and the government announced a temporary economic shutdown, it jumped up to as much as $80. This was all in a matter of under one month's time. When we saw the VIX at $80, investors knew that fear had taken over lots of money had been taken out of the market. Supposedly, it measures volatility, but from what I've gathered, it behaves as if one were to short the market. Similar to shorting, buying VIX shares does the same thing. It's more of a fear gauge than a volatility meter. If the stock market were to have huge volatility to the upside, the VIX would come down hard.

In the scenario above, the VIX climbed to the top in only 21 days. What I like to point out here is that the VIX clearly has more upside potential than to the downside. If you entered the trade at the $20 mark, the risk to reward was immensely in your favor. In hindsight, if you were to purchase one share of the VIX on February 21 and got in around $18, you were either risking all of your $18 for the potential of making $67.40. That's around 4X what you would've risked had you got in. Coincidentally, the VIX took about four times as long to return to pre-crash levels.

The VIX is telling us that when the market crashes, it comes sudden and aggressive. Understanding when to get in the VIX is very tricky because one moment your opportunity is there, and the next moment it's gone.

How to Trade the VIX

One simple way to pick your entries on the VIX are by looking at the market's relative strength. When the 14-Day RSI is above 70 (overbought) you will usually see some increase in price in the short term.

The line in orange represents the VIX and the candles are the Dow Jones Industrial Average. Notice the blue dotted line showing how RSI was above 70 on DJI before we saw an increase in the VIX. To me, RSI is one of the best indicators that tell you when stocks are over or under valued.

The VIX trades under these symbols:
-VIXY
-VXX
-UVXY
-CBOE
-TVIX

This index is purely meant for trading and is not meant to be held for years at a time. Especially in things like TVIX; your money will move at double the volatility in the VIX. TVIX just means 2X leverage which can either work out very well or very poorly for you.

However, we are in times where uncertainty is high and fears of another shutdown are in the back of everyone's mind. You can expect heavy volatility for a while as the US government tries to figure out what to do about the economy. And risk to reward looks very good right now for the VIX, but it all depends on how much one wants to risk. Some traders have made millions on trading calls and put options on this index, but that requires perfect timing. Many have lost thousands. If you're more confident about 'where' instead of 'when', you can just purchase shares of the VIX without having to worry about an option call that expires after a given time. In other words, if you are fairly confident that the market will go down in the near future but didn't know when it would happen, it is often better to not try to not give yourself a deadline with an option call and grab some shares instead.

Conclusion

All in all, the VIX is a powerful thing to trade and can either work for you or against you just like any stock or currency. But what makes it special is that when the market is losing money, you could be making money. And you can always trade it over and over again. It also tells you how investors feel about the market. Are they confident or uncertain? Are they fearful or are they greedy? It's not only an index you can trade, but it's also an indicator in itself.

Featured Photo: https://voxeu.org/sites/default/files/image/FromMay2014/sentanafig1.png

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Disclaimer:

Please note that this email is my personal opinion only. I am not a licensed financial advisor, and any information shared or discussed is not to be construed as investment advice. Trading and investing involves a degree of risk, and is not suitable to all investors. Please consult with your financial advisor before making any sort of investment decisions.