Volatility is a word we all use, a factor we all take into account in our everyday trading and embodied in the VIX. The VIX, often lovingly referred to as the Fear Index, is actually a volatility index based on the S&P 500. As such it is a very useful indicator for traders of all variety, not just S&P traders, all traders because it can give a good impression of which way the wind is blowing through the market. Are traders scared, are they euphoric, are they complacent, is there malaise? All useful emotions to be aware of, when the market is feeling them. In fact, you might even say you could get an advantage of the average trader by using a tool such as this.
What Is The Volatility Index
The Volatility Index is a measure of the relation in prices between S&P 500 index options and the price of the index. Basically, when the price of options gets higher, as the market bids them up, the volatility index will move higher. If the market bids down the prices of options then the index moves lower. It is called the Fear Index because traders assume that when options prices are high the market is scared. This is because traders who fear the market will correct will charge as much as they can for positions they own, and traders who are looking to buy protection will chase prices as high as they go. In general, this assumption works but there is a catch. The VIX can move higher when the market is happy just as easily as it can when the market is sad so it is important to read the spikes it gives relative to market conditions.
Consider this. If traders believe the S&P 500 is going to move higher and they begin to buy calls and bid up the price it can cause the VIX to rise. The reason it doesn’t cause the same magnitude of spike that a correction can cause is that, in general, when traders are bullish on the market in such a way it tends to rise along with the options which keep the VIX trending sideways or even lower. The irony is that it is possible to trade the VIX, the problem for most binary options traders is that your broker does not support options on it. That does not mean you shouldn’t keep track of it because you should. There are at least two (4) major signals it can give; bearish trend, bullish trend, impending correction/reversal and confirmation of support/resistance.
Reading The VIX
Historically the VIX trades within a set of trading ranges with secular, long-term, short-term and near-term relevance. In terms of fear and reading the market in general lower readings are bullish and higher readings are bearish. High readings over 20 are indicative of bear markets while low readings below 15 are generally associated with bull markets. This means that you read the chart of the VIX opposite of the S&P 500. If the VIX is bullish the S&P 500 is bearish, if the VIX is bearish, the S&P 500 is bullish.
Reading the VIX is a key aspect of technical analysis, and can be read with technical analysis. The VIX is displayed in a price chart just like an index or forex pair. Any and all forms of technical analysis can be used to predict movement.
The first two signals are understanding where the market is, and where it is going. It’s one thing to know the market is at bear market levels, it’s quite another to know it’s at bear market levels and moving up/down from there. A VIX that is trending higher and/or showing a signal that suggests a bull market in the VIX is indicative of a bear market in the S&P 500. These signals are OK but really not a reason to make the VIX a must-have part of your toolbox.
The reason the VIX should be in your toolbox is due to reversal signals. The index, in both bull and bear markets, is particularly sensitive to reversals. Price action along with standard tools such as MACD and stochastic are more than enough to spot impending points of reversal and correction. When found on the VIX chart these signals become high probability trades on the underlying index and broad market indices in general that can be relied upon. In a trend following situation, they provide not one but two signals, the reversal and then the entry point for trend following positions.
Don’t Fear The Fear
Bottom line, you should not fear the fear index. This index, while rarely used in a direct sense is something you should keep track of on a week to week basis if not at least once a day. It is an invaluable tool into the psyche of the market indicating trends, reversals, corrections and even day to day activities on the S&P 500. If you trade the market it’s a good idea to use the VIX if you trade the S&P 500 in any shape or form it is a requirement so don’t waste time, dig deep and start using it to make profits.