During a market
downturn the VIX is a commonly referenced indicator. The value of the VIX is derived
from the price of out-of-the-money S&P 500 (SPX) put options and will
increase as SPX declines. Given this behavior in the VIX, it can be used as a valuable trading tool on its own and in combination with other indexes or indicators.
For example,
one of the most common strategies is buying put options on the SPX when prices
begin to top or decline. In other words, the VIX can be used for a simple
equity market hedging strategy. This buying of SPX put options will cause the
implied volatility to rise, resulting in higher premiums for the options. Since
the VIX measures implied volatility of SPX index options, it will move
inversely with the SPX. That is, as prices fall there is more put option buying
which results in higher VIX levels.
Not only
does VIX increase as SPX declines, but it also has a tendency to increase more
quickly the faster and farther the SPX declines. For example, Russell Rhoads
found in his studies that “for the 500 worst days of performance volatility
actually increased more than the S&P 500 lost over 90% of the time.” In
other words, the demand for protection outpaces the decline in SPX prices the
majority of time in this sample. He continues by saying “even with the 1,000
worst days being measured, over 85% of the time volatility increases more than
the market loses.” There are several useful implications from these findings
for a trader.
Namely,
these outsized moves in the VIX compared to SPX as described by Rhoads are
ephemeral. That is, the VIX is best used as a short term trading indicator. Specifically, Rhoads conducted a study where he
compared moving average trading systems of various lengths and then added a VIX
filter to these systems. Each single moving average system would be long the
SPX if the price of the index was above its respective moving average (i.e. 20,
50, or 200-day moving average). He then added a filter where each system was
long the SPX when above its respective moving average and the VIX is below its
corresponding moving average. He found that “as the length of the moving
average is increased, the effectiveness in using VIX decreases.” Accordingly,
VIX loses its utility as time horizons expand. He continues by stating, “Spikes
in volatility happen quickly and then the market returns to normal over time.”
Additionally,
traders can compare the VIX futures prices to the price of the VIX index.
Prices for VIX futures contracts are dictated by traders’ outlook for
volatility until the specified contract expires. Or, as Rhoads says, “VIX
futures anticipate the direction and level of the VIX index or implied
volatility of the overall market.” It is important to note that placing directional bets on VIX futures
are wagers on a change of trend in the S&P 500. That is, if traders buy
more near-month VIX futures than they sell then they are expecting a decline in
the SPX.
Additionally,
VIX futures can be used to forecast the appropriate level for the VIX index.
For example, when the VIX is at a discount to the VIX futures it implies that
traders are pricing in more price weakness for the SPX and a rise in the VIX
index. The converse is true when the VIX index is at a premium to it futures.
Additionally, the near-month contract is usually the most active and, as a
result, the best indication of the market’s expectation for volatility over the
short-term.
Similar to
the aforementioned study, Rhoads finds that when the SPX experiences a
significant down day (e.g. -2.5%) only a small percentage of the price
increases in VIX futures is less than the move in the SPX (i.e. less than 8-13%
of the time depending on the number of testing periods). Moreover, Rhoads
states that “using the futures prices relative to the index as an oversold or
panic indicator would result in better performance relative to the SPX since
2007.
Another
method involves using the put-call ratio of options to get perspective on
market sentiment. Generally, call volume will exceed put volume for equity
options. However, during periods where traders display less risk appetite this
behavior can reverse. Also, tracking historical put-call ratios will allow for
traders to determine a reasonable basis for a historical range and identify tradable extremes.
For example,
when the equity put-call ratio enters into its lower boundary of its historical
range, traders may choose to buy VIX call options. That is, when there is an
extreme amount of call buying (bullishness) by equity traders this has
historically preceded a meaningful reversal of trend. Buying call options on
the VIX, which moves inversely to the SPX, will provide a hedge for traders.
Furthermore,
as with SPX, traders can use a VIX put-call ratio as an indicator for stock market direction. Rhoads found through his research that the VIX put-call ratio
is best used for short-term trading of SPX on the short side.
The VIX can
be a useful indicator for stock market direction of the short-term as well as
improve your market analysis. The examples above provide some basic models that
can improve your trading. Additional research could be done to look at
lead-lag indicators, seasonality of the VIX, or in conjunction with another
parameter. However, do not include too many parameters in your trading model or
you will likely over-fit the data and create a less robust solution. Simple
rules typically work better.
As always,
please feel free to contact me with any comments or questions. Thanks for
reading.
John
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