4 VIX Trading Strategies – Understanding the VIX Index and Its Functionality
An article about VIX trading strategies and explaining: 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.
(We have made potential trading strategies based on volatility – volatility trading strategies. Please check out our strategy bundles.)
“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.