You will often hear option traders talking about the VIX. Many traders are really not sure what the VIX is and how its used. This article will explain the VIX and provide a proven method of using it to locate profitable trades.
The VIX was first used in 1993. It’s built upon an idea credited to Professor Robert Whaley. The VIX is weighted mix of prices for a variety of options on the S&P 500. The options are based on the expected volatility or price change over the next month. I like to think of options as an insurance policy with the premium increasing as the risk level climbs. This is very similar to automobile insurance. The more accident, hence risky you drive, the higher the price of your auto insurance. The same thing can be said for option prices.
The higher the VIX, the greater number of investors who think that stocks will plunge in value. The number of the VIX represents the annualized expected percentage down move of the S&P 500 over the next 30 days. (If you are mathematically inclined, the VIX is calculated as the square root of the par vairiance swap rate for the next 30 days.) The number has been as low as 9 and as high as 89 during the financial turmoil in 2008.
A smart way to look at the VIX is as the S&P 500 upside down. As the VIX moves higher, the S&P 500 moves lower. When the VIX moves lower, the S&P 500 generally travels higher. The VIX is called “the fear index” for a reason. The greater the fear in the market, the more traders hedge their positions with options, driving up the price of the options, therefore the price of the VIX.
Now that you understand what the VIX is, how can an investor put it to work?
I have found that researcher Larry Connors has developed the best way to use the VIX.
He calls the method “the 5% rule.” Whenever the VIX is trading 5% below its 10-day simple moving average, the S&P 500 has lost money on a net basis five days following.
The opposite has also been extensively tested and proven accurate. Whenever the VIX has been 5% or more above its 10-day simple moving average, the S&P 500 has earned returns better than two to one compared to the average weekly returns of all weeks.
Basically, Larry is using the VIX as a dynamic rather than static indicator. Most traders just look at the number itself, but using it dynamically has proven to be the better way.
