Volatility Index: What to Know and How to Get Started

Ruben Leija

The Volatility Index (VIX) tends to spike during stressful, and uncertainty in the markets. During the recent Covid pandemic shutdown, on March 20, 2020, the Volatility Index hit as high as 85 and the S&P 500 (SPY) declined about 34%.

Key Takeaways

The Volatility Index can be used to help hedge against volatile markets.
The Volatility Index can be used to help understand market sentiment.
If the Volatility Index value is above 20 it’s expected to have high volatility in the stock market in the next 30 days.
If the Volatility Index value is below 20 it’s expected to have low volatility in the stock market in the next 30 days.

What is Volatility Index (VIX), Exactly?

The Volatility Index (VIX) also known as the “fear index” measures the volatility of the stock market over the next 30 days.

Imagine the Volatility Index like a weather forecaster, but instead of predicting the weather, it predicts how calm or volatile the stock market will be.

How Does Volatility Index (VIX) Work?

The Volatility Index (VIX) is a numerical value between 0 to 100. A low Volatility Index value indicates that stock market will expect low volatility. On the flip side, a high Volatility Index value indicates that the stock market can expect high volatility.

What is considered a high volatility number? If the Volatility Index value is 20 or higher, it’s considered high. Anything below 20 is considered low.

Okay, but how is this value calculated? The Volatility Index (VIX) follows a set of prices of the S&P 500 (SPY) options that are close to the money. The Volatility Index also takes into account the measure of how many traders, and investors are willing to pay for the options that protect against the market volatility.

The higher the demand for those types of options, the higher the Volatility Index rises.

Pros and Cons

Pros

Allows traders and investors to get a feel for the market sentiment.
Can be used as a hedging tool to protect for market downtrends.
Has a 30-year track record of being a reliable tool in the financial industry.

Cons

Can be influenced by other factors such as news and world events.
Does not provide insight to long-term trends beyond 30-days.

The Volatility Index is just one of many tools that traders and investors use to manage risk, and make trading or investment decisions. It should not be the only tool to be reliant on, and is best fit with other market indicators.

Should you Trade the Volatility Index (VIX)?

Trading the Volatility Index is not for everyone, but it can work well for some.

Traders who are comfortable trading options: The Volatility Index is not a stock you can buy, it only has options.
Traders who are comfortable with high volatility: The Volatility Index can make wild moves up and down, and the options premiums can fluctuate with wide ranges.
Experienced traders: The Volatility Index requires to be aware of the market sentiment overall

How to Trade Volatility Index (VIX) in 5 Steps

Here’s a quick getting-started guide.

Step 1: Choose your Favorite Brokerage

If you have a favorite brokerage account, go there first.

Step 2: Identify Support and Resistance & Market Research

Find the Volatility Index symbol (VIX), and start doing technical analysis, and doing market research. You’ll want to get a feel for upcoming world and economic events.

Step 3. Execute Trade

Pick your option contract, go long or put, and monitor your trade on the Volatility Index. Make sure to take profits, and set a stop-loss to protect your hard earned capital.

Step 4. Review Trade

After the position is closed, journal your trade on the VIX, and look for any mistakes so you can avoid them next time.

To Sum It Up

The Volatility Index is a great tool for traders and investors to get a feel for market sentiment. But should not be used as a standalone tool.

Use other indicators and tools to give you a clearer picture of the overall market.