Understanding the VIX and Incorporating It Into Our Perspective
On January 4th, 2022, the CBOE Volatility S&P 500 Index (VIX) logged its low for the year at 16.36 and then spent the next 21 days (about 3 weeks) rallying to this year's high of 38.94 on January 24th, 2022. Price action since then has remained between these price extremes for the year. The VIX’s January 24th, 2022 peak marks a new high since October 20th, 2020, 451 days (about 64 weeks).
Technically speaking, the VIX has recorded higher highs and higher lows since February 9th, 2022, followed by lower highs since February 24th, 2022. Inside price action since February 25th, 2022, suggests an inflection point for the VIX. A breakout above 37.79 will likely show us more sustained high volatility in the near term. A breakout below 26.93 will likely show us the opposite, a continued decrease in volatility in the near term.
What is the VIX?
The VIX is an index that helps us understand the expected velocity of price movement for approximately the next thirty days, derived from short-term S&P 500 (SPX) index options. Since options are derivatives with a price that is based on the expected move of the underlying, they are used to calculate volatility. Furthermore, since options are time sensitive, they provide the VIX volatility calculation with a time variable that provides us with forward-looking expectations.
Interestingly, the VIX does have a mean reverting quality. The mean price of the VIX since May of 1990 is 19.48. Since we know the SPX index traded before 1990 and continues to trade through the present day, there has always been a forward-looking expectation that the SPX index price will move. As a result, the VIX has never fallen to zero. In fact, the CBOE Volatility S&P 500 Index (VIX) has never fallen below 8.
Fig. 1: A VIX index distribution graph that shows where price has been recorded since 1990.
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If we base our assumptions about the value of the VIX index on historical volatility calculations, we can assume that the higher or lower the VIX goes the more quickly it will want to return to its mean. We can interpret this phenomenon by understanding that the market wants to discover the most efficient market price and transact at that level if it can. The market will resist extreme movement until it no longer can, which leads to a breakout in price and a spike in volatility.
How to trade the VIX
The VIX index led to the creation of trading instruments that provide traders with direct exposure to volatility. The VIX futures contract began trading in March of 2004 and options on VIX futures began trading in February of 2006. The popularity of volatility-based trading has sprouted a variety of volatility-based products that can be used by institutions and retail traders alike to invest, hedge, and speculate on the volatility of nearly every equity that the market has to offer.
Understanding volatility indexes and their tradable products allows us as traders to gain insight into the market and make assumptions about the sentiment of market participants. It is then up to us as traders to interpret that information and incorporate it into our perspective. Our perspective, with volatility in mind, has the potential to allow us to make better predictions about where we think the market might move to next. Thereby allowing us to make more accurate trades and be more efficient traders.
To trade VIX futures or other volatility products, open an account on tastytrade.
CBOE Crude Oil Volatility Index (OVX)
A specific example of a volatility index and its relationship with a tradeable underlying is the CBOE Crude Oil Volatility Index (OVX). We can reference the OVX index to gain direct insight into Crude Oil Futures (/CL). The higher the OVX price moves, the more velocity we can expect from the movements of the Crude Oil Futures price in the near term.
This relationship is certainly true today as we see the OVX moving above 70 this morning with strength as Crude Oil Futures (/CL) contracts continue to rally through the low 100s. If the OVX index remains high, we can expect high velocity moves in /CL in the near term.
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