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One of the hallmarks of this current market trend has been the extreme market volatility. A sharp, nearly 95% rise from a 15 reading in mid-February to the high 20’s has everyone concerned. If you learn how to use the VIX to guide your trading, you will have an edge over many traders.

What the VIX tells us

The VIX (volatility index) is one of many indicators that provide a picture of future market moves. It measures implied movements over the next 30 days – what the market expects an index to do. Because it is an expectation, it is not a guarantee, and it’s not always right.

Volatility is based on option pricing, and the VIX follows the rule of 16. If the implied move is priced at 16, then the expectation is the stock market will move 1%. If it is at 32, then the implied move is 2% and so on. With a current VIX around 24, we can interpret the implied move to be about 1.5%.

A higher VIX means the range in which prices are moving is expanding. With the possibility of a stock price or entire index swinging wide from one price to another, traders and investors get nervous and sell. They do this regardless of whether the index is moving at the same rate (see the rule of 16!).

For example, if an implied move of 50 points in the SPX500 is expected, a move downward will be painful. Who wants to experience that kind of loss? No one!

How to use the VIX to your advantage

Historical trends in VIX are useful tools. The average price of volatility is around 20 (give or take). Large surges in volatility reflect high levels of fear, which are good contrarian indicators to buy the market. Conversely, a very low VIX reading (in the low teens) shows high complacency, which is a setup for a new bearish trend to develop (like what we saw recently).

With a higher VIX, option prices are elevated, making them much more expensive to purchase. With the expectation of large moves, market makers price those moves in accordingly.

Learn how to use the VIX as a guide into and out of trades. Stay on top of volatility trends, and you’ll have a trading edge.

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