VIX index: how to trade volatility

The VIX index is a very special tool.

It measures the volatility of financial markets, especially equity markets, giving investors an idea of ​​the magnitude of price fluctuations in the following weeks. Technically, the VIX Index is calculated using S&P 500 option prices with an expiration date of 30 days. This means that only US stocks, especially larger ones, directly affect its value. Despite this, for a number of reasons that we will see in the course of the guide, it is also effective in providing a general estimate of volatility in other markets.

What is the Vix exactly?

The VIX comes from the Chicaco Board Options Exchange (CBOE). This is a Chicago-based exchange that specializes in options trading. Also called the “index of fear”, this tool is used by investors around the world to understand what phase the market is going through. If the market is in a phase of severe fear and major shocks, the value of the VIX will be quite high. If the market is in a period of calm and minimal uncertainty, the value of the VIX will be low. In general, periods of great volatility in financial markets are for “big stomachs”, for people willing to accept high risks in exchange for potentially very high returns. Conversely, periods of low volatility are when more cautious investors with a more moderate risk / reward profile enter the market. Understanding what an option is is key to understanding what VIX is, so we need to start with an explanation of these tools.

How to invest on VIX

Traders can invest on VIX with a lot of instruments like:

• futures and mini-futures
• options and mini-options
• ETF with or without leverage
• CFDs with Pepperstone or Avatrade broker

Traders can use VIX for 2 type of strategies

1. to cover the risk of stocks portfolio buying VIX
2. to invest for long spikes aspected on VIX (when it is very low)

The options on the vix

Options on the vix are contracts that have a duration, an object and an exercise price. The contract is signed by two investors: the first undertakes to sell to the second, at maturity, the assets in question. The price at which he will sell them to you is exactly the strike price. Options on the VIX work like options on stocks or indices.

For example, suppose an Adobe option is currently worth $ 500. Investor A estimates these shares will be worth $ 505 in a month, while Investor B estimates they will be worth $ 495. profit from his forecast by buying Adobe stock, while Investor B could short sell them to try to profit from the downside he expects. Both of them, in this case, should invest their money today and keep it busy for a month. However, by agreeing with each other, they could try to profit from their forecasts without immediately blocking liquidity.

Like? “Or what?

Through an option: the expiration of the option will be 30 days, the object will be a series of Adobe shares and presumably, the two will agree on a strike price of $ 500, a price halfway between their forecasts. If not, Investor B will sell the share to Investor A for $ 500.

Here’s what can happen: If A is correct, he can buy Adobe stock on the market for $ 495 at maturity and sell them to B for $ 500 for $ 5 per share, if B is right, he can buy Adobe stock from A for $ 500 at maturity and resell them on the market for $ 505 for $ 5 per share.

Why does the Vix index fluctuate? And on what?

The insight into using option prices to calculate volatility in financial markets is very interesting. The further the 30-day option strike price is from the current share price, the greater the expected volatility.

Conversely, if the current prices are close to each other and are close to the current price of the stock in question, low volatility can be expected. Let’s take the example of Adobe’s actions in the previous paragraph; the two investors had divergent forecasts of $ 10. This $ 10, on the current value of the shares ($ 500) represents 2%. The two investors therefore expect 2% volatility in the value of Adobe shares over the next 30 days.

Obviously, taking two investors as a benchmark is not enough. In order to create a meaningful model, you need to have many options to average on. This is why the Chicago Board Option Exchange, which is the largest stock exchange in the United States dedicated to the sale of options, is instrumental in the publication of the VIX index. If the same investors had predicted a price of $ 600 per share and the other a price of $ 250, their predictions would have been a long way off.

Away from each other and from the current price, the volatility expected by both would therefore have been very high.

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