Did you know that the VIX is an index, a technical indicator, and a security that you can trade?
It’s true – and the VIX is arguably the most effective gauge of risk and market sentiment available to investors and traders.
And I use this indicator daily to zone-in on the directions of the markets.
Once I get a decipher direction trend…
From my pre market momentum analysis…
I then make sure to reference this indicator before I place any trades.
Unfortunately, there are very few indicators available to traders that are able to predict the markets!
Since many traders use traditional indicators, they are actually using backward-looking price action.
And that means they might be given a wrong signal when placing a trade.
Which is why I want to show you how the Volatility Index VIX can solve both problems, since it can be both timely and actionable, putting you in a better spot to win on your trades.
The strategy used at Daily Deposits is to predict the direction of the markets by simply using clues found from a proprietary set of pre market momentum indicators.
And when analyzing the pre markets, one of the non-traditional indicators I always keep an eye on is the VIX, or Volatility Index.
The way that I see it… the VIX is more than a fear gauge of the market. It is a head start to the direction that the market is taking and it’s one of my personal favorite indicators to trade with.
But what…maybe you never heard of the VIX?
That’s ok! Here’s a quick review of what the VIX is and how it’s used to trade the S&P 500.
What is the VIX?
The VIX is a symbol for the Chicago Board Options Exchange’s Volatility Index. The volatility index is a measure of the implied volatility of all of the options in the S&P 500.
Now, you may have heard of this indicator by other names, such as the VXX, “investors fear index”, or “the fear gauge of the markets”… just to name a few.
Note: It’s important to note that we will be reviewing the CBOE futures index, VIX, not the ETN, Barclays VXX.
Here’s an example of what the VIX looks like.
Now let’s dig into this deeper and see what the VIX represents for a trader.
What does the VIX represent?
The VIX represents the market’s best prediction of near-term market volatility. Implied Volatility is the option’s market expected volatility of the underlying asset, in this case, the SPY.
This value is the indication of implied volatility by the option’s market which lets investors know if they should experience stability or turbulence in the near term.
And there are many ways a trader can use this information for their trading.
- VIX > 20 : markets are in a risk-off market environment
- VIX < 20 : markets are in a risk-on market environment
Next, let’s take a look at how to read the VIX if it’s reporting a 30% reading.
For example, if the VIX is reading 30, or 30%, means that the market is pricing in an annualized movement over the next 30 days.
Ok – so that might have been confusing… Let’s break it down a little further.
A value of the VIX indicates that the SPY is priced to move 2.5% over the next month. This is calculated by taking the value of the VIX and dividing the annualized number by a 1-month projection.
In this example, you will have 30% / 12 months = 2.5% movement of the SPY priced in by the VIX in the next 30 days
Note: This is a general movement up or down. There is no indication (yet) of the movement being higher or lower without analyzing the VIX further.
The VIX : SPY
Now that we have some of the basics and calculations of the projected movement covered, let’s take a look at another way to use the VIX chart.
In this example we are going to chart the VIX and SPY overlapped and look at the relationship between the two values.
This should give us an interesting view of the markets and provide the trader with information with what direction the markets may take for the trading day ahead.
Let’s take a look at what this shows on the SPY : VIX overlaid with one another.
Taking a look at the blue vertical lines, we can see that each spike of the VIX (bar chart) aligns itself with the SPY’s lows (the line chart).
This means that investors are fearful and that they are leaving stocks as the prices drop lower and causing the VIX to spike higher.
Now with each spike of the VIX you can see the SPY’s are heading lower, and that is why they call the VIX the fear gauge of the markets.
But just because the VIX is elevated doesn’t mean to go short the markets. In fact, sometimes the opposite is true.
Now … let’s take a look at how to use this to predict the direction of the markets.
DOES VOLATILITY ACTUALLY PREDICT THE MARKETS
As we already covered, it’s common to hear the VIX called the “fear gauge” of the stock market.
Basically this indicator says, when the values of the VIX are high, investors are more fearful compared to when values of the VIX are lower.
But… are there price predictability powers that are built into this indicator?
In short, absolutely!
By keeping a real-time VIX on your screens when considering entering a trade gives you a look into the feelings the entire market is having toward the price action.
Here are 5 key ways to analyze the VIX for signals to trade the SPY:
- Rising VIX + rising S&P 500:
- Bearish divergence that predicts shrinking risk appetite and high risk for a downside reversal.
- Rising VIX + falling S&P 500:
- Bearish convergence that raises the odds for a downside trend day.
- Falling VIX + falling S&P 500:
- Bullish divergence that predicts growing risk appetite and a high potential for an upside reversal.
- Falling VIX + rising S&P 500:
- Bullish convergence that raises odds for an upside trend day.
- Divergent action between S&P 500 and the other index futures:
- lowers predictive reliability. This often yields choppy price action or whipsaws, confusion and range bound conditions.
What does this mean?
From swing trading to intraday divergences, there are many ways to view the VIX and the signals that it gives to you every day.
And as the price of the VIX continues to drop every day, we know that the markets are starting to be in a risk-on mindset after what is still one of the worst economic downturns since the Great Depression,
But as you and I know, many traders have a short memory… and the fears of yesterday become a distant memory as time goes on.
While the tale of the VIX is scary, relentless, and terrifying – especially when markets are in turmoil… It is actually a great forward-looking indicator.
And if properly used, it can give a trader the heads up to what the overall market feels and give clues to the movement for the days ahead.