How to read and use the VIX for trading decisions
Like with all methods of analysis, I donâ€™t like to use them as a â€œPredictiveâ€ way of reading the markets. Iâ€™m not in the game of guessing what might happen!
But the VIX can give us insight into the strength or weakness of investor sentiment. Marry that up with Technical Analysis, your Fundamental base and the Economic environment, and you can form a robust decision making process.
The first rule of thumb for the VIX is to define its â€˜zoneâ€™ with the market trend that is in place. As previously mentioned, in a Bull market the VIX will consolidate. Identify the base range of that sideways trend and the upper range where the VIX reacts to normal market pullbacks.
Next, if the VIX starts to break or test that upper range, yet the broader trend of the S&P500 index remains in a steady trend, this is a warning for a potential shift in market sentiment. Consider it an early warning, but I do not act on this alone. My market/trend analysis must also trigger, along with any major changes in economic data.
A real insight into changing market behaviour is when the VIX rises at the same time as the S&P500 index. So prices in stocks have broadly risen, but at the same time investor uncertainty has increased. Again, this is an early warning alert that can have an influence on new positions or tightening of exit strategy on existing positions.
Donâ€™t chase the VIX. If the VIX has shifted, youâ€™ve already missed the boat. Unless there has been a change in the primary trend of the S&P500 index, you would be looking for when the VIX starts to settle back down. Especially if it has peaked around 50 points, which is typically the high level attained with a 10% pullback in the S&P500.
Never Short the VIX. The risk is for a falling market, which causes the VIX to rise. If the VIX is high, or extremely high, there is something going on the markets. Yes, the VIX will consolidate and retrace at some point, but if there is something going on in the markets that has caused the VIX to spike, there could be a lot of volatility until it starts to consolidate. There is too much Risk to the upside on the VIX.
Trading Strategy Tip
One of the approaches I use from time to time is what I refer to as a â€œSleeper Tradeâ€ on the VIX.
When the markets are trending upwards, if I identify that the S&P500 is in an Overbought environment and the VIX is trading near its low base, I might adopt a longer dated VIX call option position (either as a Long Call, or a Call Debit Spread).
Iâ€™m not expecting the VIX to make me millions. This is a very small position just to capitalise on the markets reverting back to their average (mean) when it is a little too high. Itâ€™s not an expectation for a Bear market or market crash.
For Option traders, the VIX is the trickiest of derivative markets. So you need to really understand itsâ€™ unique option dynamics in Time Decay, IV, and Delta. Itâ€™s not a beginners trade, but it is one I like to adopt from time to time.
The VIX index can give you some great insight into the broader market sentiment. Especially if you are a nervous investor who jumps at every little 2% downwards movement in the market.
As you develop your understanding of market behaviour, using the VIX, and using Option Implied Volatility for a stock can provide great insight for when to adopt certain strategies that would be best suited at the time.
But Option Implied Volatility is a topic for another lesson.