by Ian Harvey
August 27, 2019
Volatility in the market has been of little concern for the past five years or so. Looking at the CBOE Volatility Index (VIX) we can see that it has been quite consistently quiet, with just a couple of glitches along the way. But as the market has many ups and downs that need to be monitored – how can we keep a track of this? Find out here.
Recapping VIX Understanding
The CBOE Volatility Index (VIX) is a key
measure of market expectations for near-term volatility conveyed by S&P 500
stock index option prices. Since its introduction in 1993, VIX has been
considered by many to be the world's premier barometer of investor sentiment
in the market…..read more…..
Or put more simply, the VIX measures volatility in the market by gauging how many put and call options are being bought and sold on stocks in the S&P 500.
It is of benefit to know that the VIX is actually a lagging indicator, not a leading indicator as many believe. The VIX doesn't cause things to happen in the market – instead it reacts to what is happening in the market!
However, once the VIX does react, it begins to be used as a real-time measure of what is happening with the market volatility.
Use of the VIX
The VIX now becomes an integral part of the various indicators to gauge the direction of the market, how fast it's moving, and how much panic or complacency exists.
Complacency usually lasts for a long time, as can be seen in the chart above.
However, panic can set-in very quickly!
Reading the VIX Chart
For calm trading, and little volatility in the market, it is best for the VIX, according to its historical range, to be between 15 and 25.
When the VIX drops below 15 it rarely stays there for long. The lower it moves, the less normal it is; and a reading between 9 and 15 reflects market complacency; it's a warning sign if it stays there too long.
If the VIX drops below 9, it is time to take notice as there is too much complacency built into the market and traders are being too relaxed and not paying enough attention to various scenarios developing.
This is a time when you should decrease stock buying, and instead, buy puts. At this stage volatility in the market is low, and options are cheaper. As volatility increases, stock prices will fall and you'll be able to profit from the market drop.
When the VIX is trading above 25, the market is experiencing above-normal volatility. Now is when you should start moving back into the market. It's also when you should sell options to collect higher premiums, or if you are not comfortable with this situation, buy calls.
If the VIX moves above 30, historically a mini-correction is being experienced. This is a good time to be buying stocks, selling puts, or again, buying calls. An example of this can be seen in the chart above when the VIX was trading above 30 at the beginning of the year.
When the VIX moves above 40 - a very rare occurrence - it's time to accelerate your purchasing, and buy more calls.
If the VIX goes above 50 or 60 – time to buy-up big!
The VIX has jumped to levels above 70 just once - during the lows of the 2008 and 2009 correction.
How to Play the VIX
There are several exchange-traded funds (ETFs) and options that give you exposure.
But probably one of the best is the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX)
The S&P 500 VIX Short-Term Futures™ Index TR is designed to provide access to equity market volatility through CBOE Volatility Index® the “VIX Index” futures.
Specifically, the S&P 500 VIX Short-Term Futures™ Index TR offers exposure to a daily rolling long position in the first and second month VIX futures contracts and reflects the implied volatility of the S&P 500® Index at various points along the volatility forward curve.
This is an exchange-traded note (ETN) that
should be used for only short-term trading or protection during volatile
periods. It is NOT meant to be a long-term holding.
When the VIX starts moving above 15, you can buy shares of this ETN. It will begin to move higher as the market goes lower. At the beginning of the most recent correction in mid-January, the Short-Term Futures ETN was trading as low as $25.50. By the peak of the correction, it was trading above $55.
Since this is a short-term fund, you need to treat it as you would an option. Remember, the time to start selling is when the VIX moves above 30. You should be all-out by the time the VIX jumps above 40.
Shares of the Short-Term Futures ETN are easy to trade on any exchange and through any broker. Because the ETN uses futures on the VIX, it will lose value over time as result of "leakage," meaning new futures must be bought and old futures nearing expiration must be sold. Therefore, you should never buy this for longer-term protection.
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