Volatility indexes, or VIX, are common examples of barometers that gauge market sentiments. The VIX offers traders the opportunity to take advantage of volatility as a trading tool as well as an indicator of risk.
Discover how to trade the VIX and what is the best time to trade the VIX 75 strategy.
What is Volatility 75?
Volatility indexes (VIX) are widely considered the prime indicators of equity market volatility and investor sentiment. This metric shows how the market expects US 500 stock index options to perform in the near term.
Introducing the index in 1993 has become the benchmark for measuring the volatility of US stock markets. Hence, it is also known as the fear index and the fear gauge. In 2003, Volatility 75 was redesigned to reflect the benchmark status of the index in light of its growing importance. The VIX is based on a wider index, the US 500, which can reflect anticipated market volatility far more accurately.
Understanding VIX
The VIX as a volatility gauge generally indicates the level of complacency and fear among the investors. Usually, the volatility index stands at 30. However, when the VIX reading is above 30, it indicates a high level of fear and volatility in the market.
Whereas, when the VIX reading is below 30, it indicates complacency or a common fear in the market. Thus, during periods of high volatility, investors tend to be more cautious in the market and vice versa. Inherently, the VIX correlates inversely with the US 500.
So, when the US 500 goes downward, it pushes the Volatility 75 higher to reduce fear in the market. However, the Volatility 75 index only measures the market’s volatility and does not determine future direction.
How to calculate the VIX?
A volatility index like the VIX differs from the stock indices like the US 500, which uses a price index to calculate their component stocks. Generally, the VIX indicates the near-term volatility of option prices by averaging the weighted prices of SPX (S&P 500) Puts and Calls over a wide range of strike prices. The only significant amendment to the formula is to expand S&P 100 to a wide US 500 that took place in 2003.
After updating the index, a wide range of strikes are now included in its computation, whereas in the past, it was only based on at-the-money options. However, to compute the VIX, follow the following mathematical steps:
- Select options with expiry dates between 23-37 days.
- Calculate how each option contributes to the overall variance.
- Calculate the total variance for the first and second expiration.
- After that, determine the 30-days variance by interpolating the two variances.
- Then, calculate volatility as a standard deviation by taking a square root.
- Finally, calculate the Volatility 75 by multiplying the standard deviation by 100.
How to trade VIX signals
A Volatility 75 index chart aids in predicting market cycles by measuring the impact of fear as a primary ‘fear barometer’. VIX readings above 30 typically indicate increased investor fear, while readings below 30 generally indicate general complacency.
Taking its cue from the options market, the Volatility 75 Index measures implied volatility. As a result, the VIX typically displays sideways to gradual downward movements, indicating the long-biased stock market. Sharp investors are warned of potential complacency in the market by the VIX’s sustained low levels.
When market declines occur, market participants tend to overreact and buy Put options to cover their positions. Volatility 75 Index prices are rising because investors are over-fearful. In anticipation of a long-term increase in price movement, traders can use this spike in the Volatility 75 Index to detect a temporary or definitive bottom in the market.
When there is a general bullish trend, this strategy is especially ideal since it looks for optimal price entry points in the general trend direction. Conversely, during periods of sustained lower VIX readings, investors can pick up market peaks because complacency is apparent.
April 24, 2004, marked the first trading day for VIX futures. A VIX options offering was also launched in February 2005, and they have since become one of the most traded derivatives assets. In addition, the typically negative correlation between VIX futures and options and the stock market has provided a natural hedge against stock and index market positions.
When to trade VIX 75?
To make consistent profits with Volatility Index 75, traders must wait for the best time. Unfortunately, trades often occur at the wrong time, which leads to account losses (the account balance ultimately blowing up).
Professional traders win their trades most of the time if they act at the right time, have the right trading skills, are patient, have a good frame of mind, and are in a good place mentally. Unfortunately, the Volatility Index 75 trades successful traders don’t execute almost all of their trades.
The Volatility Index 75 tends to be entered at the point of breakouts or reversals, where the best trades are entered.
Moreover, candlestick patterns have also been shown to predict profitable trades at the right time. Engulfing candlestick patterns and pin bars are examples.
The Volatility Index 75 price forms support and resistance based on the technical analysis, depending on the time frame. Therefore, when price reacts to previous resistance or support levels, it’s a great time to trade Volatility Index 75.
News does not affect the Volatility Index 75 fundamentally. However, a negative correlation exists between the price of V75 and the USD-based Forex pairs, including USDJPY (and some other USD-based Forex pairs). Some of the time, Gold or XAUUSD correlate negatively with V75. In other words, the breakout or price movement occurs around the time of the following;
- 03:00 GMT
- 07:00 GMT
- 11:00 GMT
- 15:00 GMT
- 19:00 GMT
- 23:00 GMT
The most critical times are 11:00 am and 23:00 pm GMT.
Bottom line
You need to look no further than the VIX index to make profits when the market is in a wild mode. When you are uncertain which direction any individual stock or asset will go daily, this volatility index is a good way to profit from volatile markets. It is a good time to invest in the VIX whenever fear or uncertainty in the market rises, as fear and uncertainty typically cause increased volatility. Conversely, traders may profit from shorting the VIX when investors are confident as volatility decreases.
