By: Montana Timpson
For all the euphoria in the U.S. equity market currently, the Cboe Volatility Index (VIX) has stayed elevated in a historic divergence between this gauge of investor fear and rallying securities. The VIX hasn’t closed below 20 since February last year. Its current level of 23 is some six points above the decade average — a historic disconnect between the VIX and the volatility it’s meant to measure.
Such instances typically happen after massive shocks in the VIX and give way to a decline in volatility. Historical data also suggests that the S&P 500 will rise as the volatility index course-corrects. For professional traders, understanding this forward-looking volatility and how to utilize VIX market risk calculations can be an incredible asset in pricing futures and options contracts. Here’s how.
The Cboe Volatility Index is a real-time market index that represents the market’s expectation of 30-day forward-looking volatility. In theory, the VIX acts a barometer of investor sentiment for future market moves; in practice, it’s a statistical calculation of market risk, derived from the price inputs of the S&P 500 index options.
The VIX is the first benchmark index introduced by Cboe to measure the market’s expectation of future volatility. Volatility, when it comes to equities, is a statistical measure of the degree of variation in a stock’s trading price observed over a period of time. Volatility attempts to measure the magnitude of price movements that an asset experiences over a certain period of time; the more dramatic the price swings, the higher the level of volatility, and vice versa. The VIX, for many professional investors, is regarded as the standard gauge of U.S. equity market volatility.
In the context of active trading, the VIX is often referred to as the “fear gauge” or the “fear index” and is used by traders to measure the level of risk, fear or stress in the market when making investment decisions.
VIX in the News
The VIX was elevated at the end of last month, following market volatility triggered by a sharp selloff of Treasury bonds. The 10-year Treasury yield rose quickly past 1.5%, which caused a ripple effect across asset classes as the rate of return on US Treasuries proceeded to exceed the estimated dividend yield on the S&P 500 Index.
Due to higher Treasury yields, stock price valuations found intense scrutiny, and the tech-heavy Nasdaq underperformed other major equity indices like the Dow or S&P 500. The pullback in stocks corresponded with a sharply higher VIX, as investors sought downside protection by buying VIX futures and call options.
Trading the VIX
As with all indices, professional traders cannot buy the VIX directly. Instead, investors can take positions in VIX through futures or options contracts, or through VIX-based exchange-traded products, most commonly in the form of ETNs. Alternatively, active traders may use the VIX to gauge whether overall market volatility is increasing or decreasing as a means of evaluating whether single stock options are likely to increase or decrease in value. For example, given that the implied volatility of a stock is a significant component in evaluating the value of a given options contract, a trader with a view that volatility is likely to increase may be more apt to purchase call options in that type of environment.
The author holds no positions in any of the stocks or indices mentioned.
Active Trading with Lightspeed
Lightspeed provides professional traders with all the tools required to help them find success in stock trading, and we have been developing and honing our active trader platform to offer an optimal user experience. With the intuitive interface layouts and institutional quality stock and options scanners, we aim to help traders reach their goals, no matter what their strategy is. We also offer our clients some of the lowest trading fees in the industry.
Data, information, and material (“content”) are provided for informational and educational purposes only. This content neither is, nor should be construed as an offer, solicitation, or recommendation to buy or sell any securities or contracts. Any investment decisions made by the user through the use of such content are solely based on the users’ independent analyses taking into consideration your financial circumstances, investment objectives, and risk tolerance.
Copyright © 2001-2021, Lightspeed, LLC. All Rights Reserved.