The Cboe Volatility Index (VIX) measures expectations for volatility in the next 30 sessions, with put and call options activity underlying its calculations. Volatility represents how much a security's price fluctuates over a period of time.
Volatility can be made measured as a variance between an asset's price and a market index, such as the S&P 500. The greater the volatility, the greater the risk associated with the security. By charting the moving averages of the VIX, investors can spot trend changes in equity markets.
- The Cboe Volatility Index (VIX) measures expectations for volatility in the next 30 sessions, with put and call options activity underlying its calculations.
- Volatility represents the magnitude of the price change in a security, such as a stock or commodity.
- The Cboe VIX shows the market's expectations for near-term price changes in the S&P 500 index (SPX).
- The VIX represents the expectation that volatility will rise or fall, which is why it's often called the fear index.
- As a result, price moves in the S&P 500 and equity markets are inversely correlated to price changes in the VIX.
Understanding Moving Averages and the VIX
Volatility represents the magnitude of the price change in a security, such as a stock or commodity. The VIX is an index that shows the market's expectations for near-term price changes in the S&P 500 index (SPX). The VIX measures the strength of price changes by using the prices of index options expiring in the short term. As a result, the VIX represents a short-term projection of volatility.
The Fear Index
Options contracts give the holder the right to buy (call option) or sell (put option) an underlying asset, such as a stock, security, or index at a set price (strike price). Options have a premium or fee associated with them, and the holder is either debited or credited that premium, depending on whether they're buying or selling the option. Each option contract has an expiration date (or expiry).
Volatility is a component of the pricing of an option contract, which is embedded within the premium. If the volatility of the underlying index, such as the SPX, is expected to rise or fall, the option premium will likely rise or fall. As a result, options premiums provide insight into the expectation of price changes and future volatility.
Since market prices can go up or down based on good or bad news, the VIX represents the expectation that volatility will rise or fall, which is why it's often called the fear index. In other words, if the market is expecting a lot of volatility from an exogenous event such as a recession, the VIX will spike higher.
Conversely, if the market expects calmness and stable economic conditions, the VIX will fall. As a result, price moves in the S&P 500 and equity markets are inversely correlated to price changes in the VIX.
A moving average (MA) is a visual representation of the historical closing prices of a stock or security for a specific number of days. The moving average is calculated by taking the average or arithmetic mean of the closing prices over the period. For example, a 20-day moving average contains the closing prices for the previous 20 days for a stock or security, while the 200-day moving average contains the closing prices of the past 200 days.
Moving averages are helpful to investors since they can help identify a stock's trend and whether the trend is increasing or decreasing. However, since moving averages are based on historical prices, they are considered lagging indicators.
For example, a 200-day moving average will have a greater lag than a ten-day moving average since it contains older prices. However, a short-term moving average, such as a 20-day moving average, will be more sensitive to short-term price changes than the 200-day. However, by plotting a stock's short-term and long-term moving averages on a chart, investors can see if recent price moves (called price action) are confirming or contradicting the long-term trend.
Some moving averages are followed closely by investors to determine trend changes. For example, if a stock's 50-day moving average crosses above its 200-day moving average, it is considered a bullish trend change, meaning the price is trending higher (or uptrend).
Conversely, when the 50-day moving average crosses below the 200-day average, it is considered a bearish signal, meaning prices are trending lower in a downtrend.
Trading the VIX
While VIX focuses on S&P 500 data, traders and hedgers can also examine the Nasdaq 100 through the Cboe Nasdaq Volatility Index (VXN) and the Dow Jones Industrial Average through CBE DJIA Volatility Index (VXD).
Moving averages applied to VIX form the basis for a wide variety of buy and sell strategies in broad-based instruments, like the SPDR Trust (SPY), as well as volatility-based futures contracts and exchange traded funds that include:
- Cboe Volatility Index Futures (VIX)
- S&P 500 VIX Short-Term Futures ETN (VXX)
- VIX Short-Term Futures ETF (VIXY)
- S&P 500 VIX Mid-Term Futures ETN (VXZ)
However, it’s best to apply technical analysis directly to the index, avoiding futures or funds calculations because pricing in those instruments decays through roll yield and contango, which reflect timing variations between future and spot prices. Smart traders can overcome this deterioration by rolling futures contracts, but funds track continuous charts that make them unsuitable for holding periods lasting longer than a few days.
Traders measure volatility trends with long- and short-term VIX charts, looking for sympathetic equity, options, and futures exposure. Rising VIX tends to increase the correlation between equity indexes and underlying components, making index funds more attractive than individual securities. Falling VIX reverses this equation, supporting a stock picker’s market in which individual securities offer better trading opportunities than index funds.
VIX Daily Moving Average
Moving averages applied to the daily and weekly VIX measure long-term shifts in market sentiment and shock events that trigger vertical spikes out of basing patterns. These sudden increases in fear levels, whether due to destabilizing economic data, natural disasters, or exogenous events, can negatively impact investor psychology. As a result, emotional selling pressure can be triggered, causing a significant drop in equity markets.
The 50- and 200-day simple moving averages work well together on the daily VIX Chart. For a reminder, the VIX negatively correlates to equity markets. Moving average crosses can mark significant psychological shifts. Typically, the VIX 50-day crossing below its 200-day signals improved sentiment (higher equity prices), while the 50-day crossing above the 200-day points to deterioration (lower equity prices).
For example, the VIX 50-day moving average crossed below the 200-day in August 2020. Despite some volatility in the markets in the days following, the S&P 500 rallied. Crosses routinely occur due to spikes and subsequent recoveries, allowing the observant technician to time the shift between rising fear and a return to complacency.
Once the spikes in the VIX in September and late October 2020 subsided, the VIX 50-day moving average diverged lower from its 200-day. As a result, the S&P 500 went from approximately 3400 in August to over 3700 by year-end.
Also, we can see that usually, when the price of the VIX moves towards its 200-day moving average, volatility subsides, and it trades sideways; likewise, the S&P 500 also trades in a similar pattern. However, once the VIX price crosses its 200-day MA, the S&P 500 moves similarly.
The momentum behind the VIX move makes a difference in the S&P 500's response and can determine the extent of the move in stocks. If the VIX is meandering around its 200-day MA with little direction, it's unlikely to create a substantial move in stocks.
VIX Weekly Moving Average
The weekly VIX chart tracks long-term shifts in sentiment, including the transition between bull and bear markets. The relationship between the VIX and the 200-week moving average is especially helpful in spotting trend changes.
The VIX spiked in October and November of 2018, which pushed the VIX 50-week moving average to cross above the 200-week. The negative correlation between the VIX and the S&P was on display as equities moved lower in the final three months of 2018 from approximately 2900 to just below 2450.
In early 2020 as the coronavirus pandemic began, fear was rampant in the markets, and the VIX responded by spiking higher to well over 80 by mid-March 2020. As a result, the S&P 500 responded by falling from nearly 3300 to 2200 (more than 30%) in just over a month's time.
As the VIX began to fall from late March to June 2020, we can see that the S&P 500 gradually rallied, passing the S&P's pre-pandemic high by August 2020. We can also see the 50-MA for the VIX crossed above the 200-MA in March of 2020. However, the moving averages lagged behind the S&P 500's recovery rally in the coming months despite the VIX falling from its highs.
In other words, long-term charts like the weekly chart will lag behind volatile markets in the short term, which is why it's important to watch the price moves in the VIX and use multiple time frames when analyzing charts.
The Bottom Line
Moving averages applied to Cboe S&P Volatility Index (VIX) smooth out the natural choppiness of the indicator, letting short-term traders and long-term market timers access highly reliable sentiment and volatility data.