VIX - Volatility Index Definition & Trading Strategies
The VIX is used to gauge the bearish or bullish nature of the broad market. The VIX does this by measuring the implied volatility of the S&P 500 index options. The VIX displays the expected volatility of the market 30 days out in the future. It is believed that the VIX is a good indication of the fear in the market. This is because if the VIX reaches extreme levels, it implies that a number of traders have purchased puts as insurance against a falling market.
History of the VIX
The VIX was first published in 1993 by Robert E. Whaley, a professor at Duke University. Dr. Whaley was able to create the first index used to track the volatility associated with underlying exchange traded futures and options. The VIX is calculated by analyzing a large number of in the money and out of the money call and put options of two expiration months for the nearest 30-day period.
VIX vs VXO
The VIX went under a major algorithm change in 2003. Originally the VIX was calculated by measuring the implied volatility of the at the money options of the S&P 100 using the Black Scholes Model and was known as the VXO. The VXO had a number of flaws due to the fact it was based off a small number of issues and not reflective of the market at large. The VIX corrected this issue by basing it off the S&P 500, which is a better representation of the market.
VIX Trading Strategy
The VIX is not like an oscillator, so in theory it has no cap on how high it can go. A basic rule of thumb is that a move above 30 indicates increased volatility. Conversely a reading below 20 indicates a passive nature in the market, with little to know volatility. The VIX was not followed much until the late 90's when there was a dramatic increase in the options market as result of the bull market and more retail participants getting involved in the market. Markets fall harder than they rise, so bear market moves often terminate with a high VIX reading. A basic trading strategy is to look for a fire sell in the broad market when the VIX indicator is over 40. Recently the VIX reached an intra day high of 75.92 on October 10, 2008, but this extreme reading was a result of the most volatile trading week in U.S. History.
VIX & Market Bottoms
Below is a chart of the VIX over the last two years. Notice how high VIX values lead to a number of market bottoms.