The VIX in Trading

The VIX, also known as the “fear index,” is an essential market indicator that measures the expected volatility of the S&P 500 index over the next 30 days. Developed by the Chicago Board Options Exchange (CBOE) in 1993, the VIX has become a crucial tool for traders and investors to gauge market sentiment, manage risk, and even devise trading strategies. In this article, we’ll explore the inner workings of the VIX, its importance to traders, and an example trading strategy involving QQQ based on VIX price action.

More Details about the VIX

Construction of the VIX

The VIX is calculated using the prices of S&P 500 index options. These are essentially financial contracts that give the buyer the right, but not the obligation, to buy or sell the underlying index at a specified price before the contract expires. By aggregating the weighted prices of various out-of-the-money put and call options with different expiration dates, the CBOE derives a measure of the market’s expectation of future volatility.

The VIX calculation is based on the Black-Scholes option pricing model, which incorporates various factors such as the time to expiration, interest rates, and the option’s strike price relative to the current market price. The resulting VIX value is expressed as an annualized percentage. It represents the expected 30-day volatility of the S&P 500 index.

Importance of the VIX for Traders

The VIX is vital to traders for several reasons. Firstly, it serves as a barometer of market sentiment, with high VIX levels indicating increased fear and uncertainty, while low levels suggest complacency and stability. By monitoring the VIX, traders can gauge the overall market environment and adjust their risk management strategies accordingly.

Secondly, the VIX can act as a contrarian indicator. When the VIX reaches extreme levels, it may signal that market sentiment has become overly pessimistic or optimistic, which can lead to potential reversals. Savvy traders can capitalize on these opportunities by taking positions that anticipate a change in market direction.

Lastly, the VIX is useful for options traders in determining the relative cost of options premiums. A higher VIX indicates more expensive options due to the increased uncertainty and potential for larger price movements, while a lower VIX suggests cheaper options premiums.

Historical Analysis of the VIX

Studying historical VIX data offers insights into market volatility evolution and its influencers. Examining VIX spikes and related financial crises or geopolitical events helps traders understand market volatility drivers. That is, these episodes impact investor sentiment.

For example, the VIX hit an all-time high of 89.53 on October 24, 2008, during the global financial crisis. This spike showcased the extreme uncertainty and panic in the market. Other elevated VIX levels link to events like the dot-com bubble burst, September 11 attacks, European debt crisis, and COVID-19 pandemic.

Analyzing long-term VIX trends helps traders identify patterns and cycles in volatility. Periods of low volatility often precede sudden spikes, suggesting that complacency can lead to abrupt market shocks. Conversely, sustained high volatility levels usually subside over time as markets stabilize and investor sentiment improves.

Understanding VIX’s historical behavior assists traders in anticipating future volatility patterns. It also helps them manage risk and make informed decisions when creating trading strategies.

A VIX Trading Strategy

Rationale

Now that we understand the significance of the VIX let’s explore an example trading strategy that utilizes VIX price action to inform trades in the Invesco QQQ Trust (QQQ), an ETF that tracks the Nasdaq-100 Index.

The strategy involves monitoring the VIX for significant changes in volatility. Specifically, we’ll look for a sharp increase in the VIX, followed by a reversal or decrease. When the VIX spikes and then starts to decline, it could indicate that the market’s fear has peaked, and a potential short-term rebound in equities may follow. In this scenario, a trader could enter a long position in QQQ, anticipating that the Nasdaq-100 will benefit from the receding fear in the market.

Conversely, if the VIX experiences a sharp decline and subsequently begins to rise, it might signal that the market is becoming complacent, and a short-term pullback in equities could be imminent. In this case, a trader could consider exiting the long position, expecting that the Nasdaq-100 may be negatively impacted by the increasing uncertainty.

Rules of the VIX Trading Strategy

Variables

  • ThreshBuy (Threshold for BUY signal) = -0.05
  • ThreshExit (Threshold for EXIT signal) = 0.075
  • VIXChange (Daily % Change) = VIX[0] / VIX[1] – 1
  • SignalBuy (Signal to buy QQQ) = VIXChange[1] < ThreshBuy & VIXChange[0] >= ThreshBuy
  • SignalExit (Signal to exit QQQ position) = VIXChange[1] < ThreshExit & VIXChange[0] >= ThreshExit

Entry and Exit Rules

  • Entry: If no position is opened, BUY max possible amount of QQQ when SignalBuy = 1.
  • Exit: If a position is open, SELL all QQQ when SignalExit = 1.

VIX Trading Strategy – Results

Backtesting is essential when building trading strategies. Let’s see below how the strategy would have performed in the past.

❗ Past performance is not indicative of future results. This is not investment advice and only for informational purposes. See the disclaimer for more information.

Performance in Recent Time Period

Backtest Results VIX Trading Strategy

For the backtested period between 2015 and now, these are the results: Exposure is 78%, max drawdown is 29%, profit factor 1.17 with a CAGR of 17.4% (QQQ reference is 100% / 36% / 1.1 / 15.2%).

Long-Term Performance

Backtest Results VIX Trading Strategy Since 1999

Unfortunately, the long-term performance (since 1999) of the strategy looks less promising. In fact, profit factor, drawdown and CAGR are all worse than buy and hold, so there’s no need to have a closer analysis here. Despite not having found a perfect strategy, it’s still interesting to see what a combination of the VIX with a typical ETF like QQQ can do, and there are many more possible approaches to using the VIX in building a profitable trading strategy (e.g., combining the VIX with sector rotation strategies).

Conclusion

The VIX is an invaluable market indicator that offers insights into market sentiment and expected volatility, enabling traders to make more informed decisions and manage risk effectively. By understanding the VIX’s construction and its importance to traders,

investors can incorporate this powerful tool into their trading strategies. Our example trading strategy involving QQQ and VIX price action demonstrates how the VIX can be used to identify potential market reversals and inform tactical decisions in the equity market.

However, it is crucial to remember that no single indicator can guarantee success in trading. The VIX should be used in conjunction with other tools and techniques, such as technical analysis, fundamental analysis, and sound risk management principles, to create a well-rounded and robust trading strategy.

In conclusion, the VIX offers traders a unique perspective on market sentiment and volatility, allowing them to navigate the complexities of the financial markets more effectively. By understanding the VIX and incorporating it into their trading strategies, investors can enhance their ability to capitalize on market opportunities and better manage risk.

Leave a Comment

WordPress Cookie Notice by Real Cookie Banner