Last Updated on December 16, 2021 by Oddmund Groette
What is the VIX and how does it work?
The VIX is a fear index and shows the price you need to pay to get insurance in the stock market. In this article, we explain what the VIX is, how it works, whether or not it can be useful for traders, and we end the article by backtesting some VIX trading strategies. VIX is a useful tool for traders and can help you build good mean revertive strategies in stocks.
“In the short run, the market is a voting machine but in the long run, it is a weighing machine.”
In the short-term, fear and greed is a major driver of the swings in the stock market. The quote above is from Benjamin Graham’s The Intelligent Investor, and we believe Graham is spot on. Morgan Housel argues that the study of finance is in practice a study of how people behave with money. This means greed and fear are some of the main determinants in the short run.
How do we measure greed and fear? It turns out the options market has a component in its pricing that is called implied volatility. The Black and Scholes formula, widely used in determining the price of options, has only one unknown component: the implied volatility.
Luckily, we can construct an index, even a futures contract, based on the volatility in the option premiums. It’s called the VIX. This is a very handy tool to measure risk and make VIX trading strategies.
Options are an insurance contract
Options are in practice an insurance contract. If you buy an option, you have insurance against a rapid increase in price if you buy a call, and insurance against falling prices if you buy a put option.
Opposite, if you write options you undertake the risk of an insurance company. Thus, you can insure yourself by buying puts if you fear the stock prices are headed south, but you can also go long VIX futures because it has an inverse relationship with stocks.
What is the VIX?
The VIX is called the fear index. Why is it called the fear index? It’s called the fear index because it measures the implied volatility of the option premiums on the S&P 500.
The higher the option premium, the higher the implied volatility. The higher the implied volatility, the more traders are willing to pay for insurance.
However, the implied volatility is not based on historical quotes, but rather on what market participants expect of future volatility. When the uncertainty is high, the higher the implied volatility and VIX values.
The implied volatility is listed with the ticker symbol VIX and is calculated in real-time. The VIX became a reality in 1993 and in 2004 CBOE established a futures contract and in 2006 an option contract. Moreover, recently a mini-contract of the VIX started trading (VME).
The VIX is thus set by the sum of the market participants. It’s a kind of equilibrium based on the perceptions about future market risk there and then.
A graphic display of the VIX:
Here is a daily chart of the VIX over the last five years:
What is a good reading of the VIX?
The VIX and the stock market are inversely related. When the VIX rises, the stock market normally heads south, perhaps depending on the velocity of the rise in the VIX (or vice versa).
A low reading means the market is complacent and could be a signal that the market participants are being too bullish and we are ripe for a negative surprise.
Opposite, a high reading might suggest the fear is too high and a rise in the stock market is imminent.
However, there is no definite answer as you need to do some quantified tests to establish what has historically worked and not worked.
As you will learn in this article, the VIX can be a handy tool when you are doing research for good strategies.
The VIX Explained mathematically
For those interested in mathematics the numbers of the VIX can be explained like this:
If the VIX is at 20, it means the S&P 500 is expected to stay within a +/- range of 20% (of the current price of the S&P 500) over the next 12 months 68% of the time (which is one standard deviation).
The VIX and the S&P 500 have an inverse relationship:
When the S&P 500 drops, the VIX increases in value:
Is the VIX correct? Is it any good in forecasting future risk?
The stock market tends to swing from euphoria to pessimism. But how well does the VIX explain the future volatility of the S&P 500?
The research we have seen indicates the VIX is better at explaining the future 20-days volatility than the previous actual volatility: about 80% of the variance can be explained by the VIX.
However, the VIX has the same human flaw of perception that is found in the equity markets that frequently drive stock prices too high or too low.
Human perception can quickly lead to greed or fear, rather than focusing on the math and fundamentals. It is easy to get sucked into the abyss of fear. This is why we recommend using quantitative and mechanical models in your trading.
Returns in the S&P 500 when the VIX is high and low – a VIX trading strategy
Let’s make our first test of the day: What is the daily return of the S&P 500 when the VIX is above and under its 20 day-moving average?
When the VIX is above its 20-day moving average the average daily return in the S&P 500 from close to tomorrow’s close is 0.05%. When the VIX is under its 20-day moving average the daily return in the S&P 500 is only 0.02%. Thus, the return is much higher when the risk premium increases, perhaps quite logical. The trend is more or less the same whatever the number of days we use as a moving average.
If the VIX is above its 10-week average, the weekly return in the S&P 500 has been 0.25%. If the VIX has been under its 10-week average, the weekly return in the S&P 500 drops to 0.1%.
In other words, we can expect higher future returns when the S&P 500 has dropped in value.
The VIX and its Bollinger Bands: a trading strategy
The Bollinger Bands are a popular trading indicator.
Can the bands be utilized to construct a profitable trading strategy? Let’s buy the S&P 500 if the VIX breaks above its 10-day upper band two standard deviations away from the moving average. This is the equity curve (compounded):
Breakout and VIX trading strategies:
Let’s try a breakout strategy in the VIX: go long the S&P 500 when the VIX breaks out on a new 20-day high and at the same time has a five-day RSI value of at least 65. The equity curve looks like this:
The RSI criterion is included to make sure the VIX is somewhat “stretched” when it breaks out. The average gain per trade is 0.63%.
A daily VIX trading strategy
Below is a VIX trading strategy based on daily bars and a holding period of one day. The trading strategy consists of three simple entry variables (entry at the close). There is no exit variable – we just sell at the close the next trading day. This is, in other words, an overnight trading strategy.
This is the equity curve in SPY from inception in 1993 until today:
We plan to publish the strategy as a monthly Trading Edge and will hence not reveal its variables.
Amibroker code for VIX trading strategies
If you want the Amibroker code for how to code the VIX and the S&P 500 you can order it here (plus you get code for Tradestation as well):
The VIX strategies overlap with other mean-reverting strategies
The VIX is mainly a short-term instrument, and thus it can mainly be used as a mean-reverting indicator. Unfortunately, it’s hard to find any VIX strategies that are better than by using, for example, the RSI or the stochastics. The trades overlap.
- The stochastic indicator
- How the RSI indicator works
- Williams %R explained
- Does the MACD indicator work?
- Are the Bollinger Bands profitable?
- Ways to use ADX
The VIX and its futures contracts:
So far we have explained the VIX index, but it’s possible to trade the index via the futures market (and options market). The contracts that are the four nearest months have the most activity. Below is a snapshot from Interactive Brokers’ TWS platform:
The snapshot shows the VIX index and the May and June 2021 mini-contracts (the VIX index is April). The contracts are in contango which means the future prices are higher the longer we get from the spot price (the index). Most of the time, futures markets converge toward the spot prices as expiration approaches.
Opposite of contango is when we have backwardation: when the contracts closest to expiration are more expensive than the longer-term contracts. This means the market is expecting a decline in volatility from today’s level.
If you test strategies on the VIX index itself, you’ll most likely find exceptional strategies with very high returns.
However, this is not applicable in real life because the index needs to be transformed into a futures contract with different prices and values. Thus, you need to backtest on the futures contract – not the VIX index. The VIX is mainly a tool to look at relationships with other instruments.
There are different types of VIX
It’s not only in the S&P 500 we can find VIX readings. It exists on Nasdaq, Dow Jones, non-US stock indices, currencies, interest rates, and commodities.
- Volatility indexes on other U.S. stock indexes
- Volatility indexes on Non-U.S. stock ETFs
- Volatility indexes on currency-related futures/ETFs
- Volatility indexes on Interest rates
- Volatility indexes on commodity-related ETFs
- Volatility indexes on single stocks
- Volatility of VIX
The synthetic VIX: Williams VixFix indicator
There exits an indicator that closely resembles the VIX: The WilliamsVixFix indicator developed by Larry Williams. Because the VIX index mainly responds to big moves in the stock market, you can use the VixFix as a proxy, especially in instruments that don’t have VIX values.
Conclusion: What Is The VIX And How Does It Work?
The VIX index is used to gauge sentiments in the markets. When the reading is high, the stock market has a higher expected future return than when the index is low. This article has shown that the VIX has an inverse relationship with stocks: When VIX is rising, stocks go down and vice versa.
Based on the very simple principle of increased risk, it’s possible to develop VIX trading strategies on both VIX itself and equity indices.