Most investors don’t like volatility…
Watching your account swing up and down like a yo-yo is enough to make even seasoned investors queasy.
It’s no surprise if the stress has you wanting to sit on the sidelines to wait out all the uncertainty.
But there’s a better way to tackle market volatility.
Keeping close tabs on the CBOE S&P 500 Volatility Index (VIX) can give you great market insights that can help your trading…
So today, I want to share two ways I use the VIX…
Fear Drives Volatility
The first thing you should watch is how the VIX often moves opposite the S&P 500.
Look at the chart below. It shows the major spikes and dips in volatility over the last year.
So, for example, the rapid rise in the VIX from mid-August to early October last year coincided with a 19% fall in the S&P 500 over the same period…
CBOE S&P 500 Volatility Index (VIX)
Source: e-Signal
And when the VIX fell from October through to early December, there was an 18% rally in the S&P 500.
It doesn’t happen every time, but the VIX often rises and falls inversely to the S&P 500 because of how it is constructed…
The VIX measures the volatility of the S&P 500 using index options (both calls and puts). Put simply, the higher the VIX is moving, the higher the expected volatility over the coming month.
The market typically falls more dramatically than it rises. And traders bidding up the price of put options is what sends the VIX higher.
So, for example, if traders see the VIX starting to push higher, they might delay a potential long trade… or instead enter a short trade.
Note, though, that the VIX is not a trigger itself. It’s simply a handy tool in helping with trade setups.
You can also see how the VIX spiked right around the middle of March. This coincided with the collapse of Silicon Valley Bank and Signature Bank.
Since then, as fears of further collapses and bank runs ease, the VIX has steadily trended down as the S&P 500 has steadily ground higher.
It’s an easy pattern to spot… And increased volatility means more opportunities to trade the wide swings volatility brings to markets.
As for knowing when to get in a trade, the VIX can help with that too…
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Knowing When to Trade
The VIX can also be useful for showing you when to trade options…
While options can be a great way to trade, one drawback is they have a finite life. The clock is always ticking on options trades.
So, if you buy an option and the planned move doesn’t pan out (or doesn’t happen within your timeframe), you can burn up a chunk of your option’s value through time decay.
And that’s where the VIX comes into play…
When the VIX is rising, it increases the odds of a bigger move taking place… And that means a higher chance of your trade coming off and making a profit.
The sweet spot for a trader is when volatility continues to rise after they buy an option…
This not only increases the chances of a bigger move… but helps increase the value of the underlying option premium. That’s because of the way option prices are calculated.
As always in the market, it’s important to remember that nothing works 100% of the time. That’s true of the VIX, as well…
But by checking out what the VIX is doing prior to entering a trade, it can help put the odds in your favor.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict