Chicago Board Options Exchange Market Volatility Index, better known as VIX, offers traders and investors a bird’s eye view of real-time greed and fear levels, while providing a snapshot of the market’s expectations for volatility in the next 30 trading days. CBOE introduced VIX in 1993, expanded its definition 10 years later, and added a futures contract in 2004.

Volatility-based securities introduced in 2009 and 2011 have proved enormously popular with the trading community, for both hedging and directional plays. In turn, the buying and selling of these instruments have had a significant impact on the functioning of the original index, which has been transformed from a lagging into a leading indicator.

Convergence-Divergence Relationships

Active traders should keep a real time VIX on their market screens at all times, comparing the indicator’s trend with price action on the most popular index futures contracts. Convergence-divergence relationships between these instruments generates series of expectations that assist in trade planning and risk management. These expectations include:

  • Rising VIX + rising S&P 500 and Nasdaq 100 index futures = bearish divergence that predicts shrinking risk appetite and high risk for a downside reversal.
  • Rising VIX + falling S&P 500 and Nasdaq 100 index futures = bearish convergence that raises the odds for a downside trend day
  • Falling VIX + falling S&P 500 and Nasdaq 100 index futures = bullish divergence that predicts growing risk appetite and high potential for an upside reversal.
  • Falling VIX + rising S&P 500 and Nasdaq 100 index futures = bullish convergence that raises odds for an upside trend day.
  • Divergent action between S&P 500 and Nasdaq 100 index futures lowers predictive reliability, often yielding whipsaws, confusion and range-bound conditions.

Charting The VIX

The VIX daily chart looks more like an electrocardiogram than a price display, generating vertical spikes that reflect periods of high stress, induced by economic, political or environmental catalysts It’s best to watch absolute levels when trying to interpret these jagged patterns, looking for reversals around big round numbers, like 20, 30 or 40 and near prior peaks. Also pay attention to interactions between the indicator and the 50 and 200-day EMAs, with those levels acting as support or resistance.

Image by Sabrina Jiang © Investopedia 2020

VIX settles into slow-moving but predictable trend action in-between periodic stressors, with price levels stepping up or stepping down slowly over time. You can see these transitions clearly on a monthly VIX chart displaying the 20-month SMA without price. Note how the moving average peaked near 33 during the 2008-09 bear market even though the indicator pushed up to 90. While these long-term trends won’t assist in short-term trade preparation they’re immensely useful in market timing strategies, especially in positions that last at least 6 to 12 months.

Image by Sabrina Jiang © Investopedia 2020

Short-term traders can lower VIX noise levels and improve intraday interpretation with a 10-bar SMA laid on top of the 15-minute indicator. Note how the moving average grinds higher and lower in a smooth wave pattern that reduces odds for false signals. It’s time to reevaluate positioning when the moving average changes direction because it foretells reversals as well as completion of price swings in both directions. The price line can also be used as a trigger mechanism when it crosses above or below the moving average.

Trading Instruments

VIX futures offer the purest exposure to the indicator’s ups and downs but equity derivatives have gained a strong following with the retail trading crowd in recent years. These Exchange Traded Products (ETPs) utilize complex calculations layering multiple months of VIX futures into short and mid-term expectations. Major volatility funds include:

  • S&P 500 VIX Short-Term Futures ETN (VXX)
  • S&P 500 VIX Mid-Term Futures ETN (VXZ)
  • VIX Short-Term Futures ETF (VIXY)
  • VIX Mid-Term Futures ETF (VIXM)

Trading these securities for short-term profits can be a frustrating experience because they contain a structural bias that forces a constant reset to decaying futures premiums. This contango can wipe out profits in volatile markets, causing the security to sharply underperform the underlying indicator. As a result, these instruments are best utilized in longer term strategies as a hedging tool, or in combination with protective options plays.

Bottom Line

The VIX indicator created in the 1990s has spawned a wide variety of derivative products that allow traders and investors to manage risk created by stressful market conditions.