3 Strategies To Trade Volatility Effectively With The VIX

The Chicago Board Options Exchange Market Volatility Index VIX, known by its ticker symbol VIX, is a popular measure of the stock market's fear and greed gauge. It shows an indication of the expectation of volatility in the next 30 days implied by S&P 500 index options.

Volatility trading is the term used to describe the volatility of an underlying instrument. Any instrument whose price changes shows price volatility, and thus, a good opportunity for investors to make a profit.

Volatility, however, is a transient phenomenon and hence, there’s always need for a concrete strategy to benefit from the VIX.

Identify the Convergence-Divergence Relationships

Source: FX Empire

As demonstrated in the charts above, the VIX and the SPX usually have a direct relationship. From the above charts, it can be seen that the spikes and curves appear at just about the same time over a 30-day period. The relationships between VIX and the most popular index futures contracts are broadly categorized into convergence and divergence—with five different variations. Understanding these variations is important before you place a trade.

• Bullish divergence— rising VIX + rising S&P 500 and Nasdaq 100 index futures.
• Bullish convergence— rising VIX + falling S&P 500 and Nasdaq 100 index futures
• Bearish divergence— falling VIX + falling S&P 500 and Nasdaq 100 index futures
• Bearish convergence — falling VIX + rising S&P 500 and Nasdaq 100 index futures
• Divergent actions— inconsistent relationship between S&P 500 and Nasdaq 100 index futures. The predictive reliability is unreliable, thus leading to confusion.

Look for Reversals around Big Round Numbers

The VIX chart is updated every 15 seconds. Therefore, it is important to pay close attention to the interactions happening across a trading window.

The VIX daily chart usually looks like an electrocardiogram, thanks to the vertical spikes of high-stress periods induced by political, economic and environmental catalysts, which lead to jagged patterns in the VIX daily chart display. Hence, one good strategy is to look for reversals around big numbers, like 20, 30, or 40. The historical average value of VIX is 20. However, it has spiked beyond 100 in shock financial events like the global financial crisis in 2008. The numbers help you gain clarity on how the market is performing. If the number is below 20, the market is stable. If the number is higher than 30, the market is volatile.

Also, it is important to pay attention to the interaction between the indicator and the 50 and 200- day Exponential Moving Average (EMA). These are the gauges that act as resistance or support.

Trade Instruments for Long-Term Profits

The most transparent volatility investments are the Exchange Traded Products (ETPs) which require a complex calculation of several months of VIX futures into short and mid-term expectations. While this may be good for investors, it may lead to wiping out of profits for the rookie trader. Unlike the stock exchange-traded funds (ETFs), ETPs do not own assets, but investors can trade them in the same way in any brokerage account. The two most popular ETPs are the VXX and the XIV. Other volatility funds include:

S&P 500 VIX Mid-Term Futures ETN (VXZ)

VIX Mid-Term Futures ETF (VIXM)

VIX Short-Term Futures ETF (VIXY)

Bottom line Trading volatility effectively with CBOE is perhaps one of the most complex bets anyone could make on the stock market, purely because it is trading the derivative of a derivative. For seasoned investors, this is a genius move and spells great opportunities for such traders. Still, with the right strategy and additional knowledge, the average investor can squeeze through its complex algorithms to make a profit.