We use a range of cookies to give you the best possible browsing experience. By continuing to use this website, you agree to our use of cookies.
You can learn more about our cookie policy here, or by following the link at the bottom of any page on our site.

0

Notifications

Notifications below are based on filters which can be adjusted via Economic and Webinar Calendar pages.

Live Webinar

Live Webinar Events

0

Economic Calendar

Economic Calendar Events

0
Free Trading Guides
EUR/USD
Bullish
Low
High
of clients are net long.
of clients are net short.
Long Short

Note: Low and High figures are for the trading day.

Data provided by
Oil - US Crude
Mixed
Low
High
of clients are net long.
of clients are net short.
Long Short

Note: Low and High figures are for the trading day.

Data provided by
Wall Street
Bullish
Low
High
of clients are net long.
of clients are net short.
Long Short

Note: Low and High figures are for the trading day.

Data provided by
Gold
Mixed
Low
High
of clients are net long.
of clients are net short.
Long Short

Note: Low and High figures are for the trading day.

Data provided by
GBP/USD
Bullish
USD/JPY
Mixed
Low
High
of clients are net long.
of clients are net short.
Long Short

Note: Low and High figures are for the trading day.

Data provided by
More View more
Real Time News
  • The #USD spent the bulk of Q2 in a range after a climactic Q1; and with a series of risk themes continuing to push, combined with an election in November, the door appears open for more vol in USD. Download our USD trading guide here: https://t.co/2Wo7EcwAht https://t.co/BA5dWk4wTt
  • $USD hegemony is at risk thanks to changes in the global economy and the long-term consequences of the US-China trade war. Get your market update from @CVecchioFX here:https://t.co/5GO9UrvO4y https://t.co/OTTEmg76W8
  • The immediate focus is on a break of this multi-week consolidation formation in the Australian Dollar with the broader rally vulnerable while below 7042. Get your AUD technical analysis here: https://t.co/iEYos1ioBc https://t.co/kuzB3Eqps0
  • #Gold prices have rallied to nine-year highs with the breakout testing multi-year uptrend resistance into the open of Q3. Can the rally be sustained? Download our latest Gold trading guide!: https://t.co/3KO2QWOnOt https://t.co/YIIGZdeIAJ
  • Why financial market traders must monitor both monetary and fiscal policy? Find out from @MartinSEssex here:https://t.co/Fkzk88Y5gm https://t.co/zerRXZC1Tq
  • Get your snapshot update of the of relative currency strength and exchange status from around the globe here: https://t.co/DmhBkd4B0k https://t.co/uj93z2SHpH
  • The Australian Dollar’s surge from the March lows may be coming to an end as bearish patterns begin to line up on multiple time-frames. Check out our #AUD trading guide to learn more here: https://t.co/pjfm07tqFd https://t.co/VypHLra1ER
  • The Evening Star candlestick is a three-candle pattern that signals a reversal in the market and is commonly used to trade forex. Learn more about the evening star candlestick pattern here: https://t.co/8OTE7m01IG https://t.co/Vumcng7UB3
  • After a miraculous recovery in Q2, equity markets will be left juggling the Fed’s policy and the threat of a second covid wave, all in an election year. Evidently, traders will have their hands full in Q3. Read our equity forecast here: https://t.co/JARqbOKIeM https://t.co/Ms6zEucjqg
  • Hey traders! I'm sure you've all heard about trend trading. Sharpen your knowledge here: https://t.co/jkliL5sxj7 https://t.co/uvlv1MCAHI
A Guide to S&P 500 VIX Index

A Guide to S&P 500 VIX Index

2018-11-02 13:26:00
Paul Robinson, Strategist
Share:

S&P 500 Volatility Index: An introduction

  • Traders should keep a close eye on the ‘VIX’, or CBOE Volatility Index, when trading major indices like the S&P 500.
  • The S&P 500 VIX correlation is a primary example of why the relationship between the stock market and the VIX is referred to as a “fear barometer”.

In this article we take a look at how the VIX is constructed, its inverse relationship to the S&P 500, as well as how traders can utilize the VIX in their stock market trading strategies.

What is the VIX in the stock market?

The VIX was created by the Chicago Board Options Exchange (CBOE) in 1990 to act as a benchmark for measuring expectations about future stock market volatility. It’s a real-time index which reflects market participants’ expectations of volatility over the next 30 days.

At the most basic level the VIX index is constructed using weekly and traditional SPX index options and their levels of implied volatility. One can think of implied volatility as expected volatility derived from market participants’ activity in the options market. Understanding why the VIX behaves inversely to the S&P 500 is important because the volatility index acts as a measure of market sentiment, hence the reason it is called a “fear barometer”.

What is the relationship between vix and S&P 500 (SPX)?

The S&P 500 VIX has a propensity to rise in bearish stock market environments and fall or remain steady during bullish environments. This happens because of the long-term bullish bias of the stock market and the fact that the VIX is calculated using implied volatility.

Implied volatility goes up when there is strong demand for options, and this typically happens during declines in the price of the S&P 500 as market participants (who are collectively bullish) are quick to buy protection (put options) for their portfolios.

When the S&P 500 rallies we see demand for protection dissipate and as a result a decline in the VIX. This process in recent years has become exasperated, in all likelihood, because the VIX has gone from just a market gauge of volatility to a tradable asset class through product offerings on various futures, equities, and options exchanges.

A Guide to S&P 500 VIX Index

S&P 500 VIX correlation

The S&P 500 VIX correlation is simply how the S&P 500 and the VIX move relative to one another. From the chart above it’s easy to see the strongly negative correlation between the stock market and the VIX. Stock market slumps lead to spikes in the index. Dating back the beginning of the VIX in 1990, the correlation between daily changes in the S&P 500 and VIX is -77%. Over the past 10 years the inverse correlation has become even stronger at -81%, while prior to October 2008 it was -74%.

The tighter relationship could very well be attributed to the various products introduced over the past 10-15 years which allow market participants to trade the VIX. As said earlier, this would also make sense as to why we are also seeing larger spikes in the VIX when the market weakens, as trading of the VIX itself is causing exaggerated moves in implied volatility.

The relationship between the S&P 500 and the VIX has largely been consistent and reliable over the years, though. The rolling 1-year correlation between daily changes has on average been around -83% over the past 10 years, staying within a relatively tight range of -70% to -90%.

S&P 500 VIX chart: One-year rolling correlation

A Guide to S&P 500 VIX Index

Using VIX to predict S&P 500 Volatility

The S&P500 VIX can be used to identify market turns, more specifically bottoms. Because the stock market tends to rise in a gradual fashion the VIX too will decline in a gradual to sideways fashion. This can lead to very low levels which warn of complacency as investors feel no need for protection, but these periods can last long enough that using the VIX as a sell signal can be rendered largely ineffective.

However, because the S&P 500 is long-biased by nature, when there are declines investors buy protection (put options) quickly, driving up the VIX. Often there is an overreaction by market participants when the market declines, hence the reason why the VIX is called a “fear barometer”.

The spike-like behavior which the VIX exhibits during times of market stress can be a timely signal for determining when selling has become overdone and the market is due to bounce or even bottom for a longer-term move higher. This strategy is typically best employed when the VIX ‘signal’ arrives within the context of a generally bullish trend in the S&P 500.

S&P500 VIX chart: Spikes can be used to indicate trading bottoms

A Guide to S&P 500 VIX Index

Circling back around to the complacency factor seen when the VIX is at very low levels, there is a nuance to this which can help identify when the stock market may be nearing a turning point to the downside, but they don’t happen frequently. When the VIX and S&P 500 both rise together over a period of time it can indicate growing instability in the trend which sets the market up for a sell-off.

Find out more about measuring volatility in the financial markets.

Using S&P 500 volatility for risk management

When trading the S&P 500 there should be an inverse relationship between trading size and market volatility, or the VIX. One common mistake traders make is that they will simply trade a fixed lot size regardless of the distance their stop-loss is away from the entry price. This means the at-risk amount of capital will be highly variable (likely due to levels of volatility) and thus lead to inconsistent results. Additionally, a trader is putting themselves at greater risk when they should be doing the opposite.

A prudent approach to risk management is to determine how much of your capital you are willing to risk per trade and then adjust the trading size accordingly. For example, if you are willing to risk 1% on an S&P 500 trade and have a 10-point stop-loss, and have another trade where you are willing to risk 1%, but with a 5-point stop-loss, for both trades to equal 1% in risk the second trade would need to be twice as large as the first trade given the distance to the stop-loss. This provides a dynamic approach to position-sizing when trading the S&P 500 for more consistent results.

Average True Range (ATR) and the VIX

On average, the distance to your stop-loss will largely depend on the level of the VIX. Another way to measure volatility is with ATR (Average True Range). From the chart below, you can see that ATR and VIX look very similar, despite ATR using historical data and the VIX calculation relying on an options pricing model. When the VIX spiked so did the trading ranges of the S&P 500, which means a trader using a dynamic position-sizing strategy would adjust their trading size down to account for the new level of volatility. Simply put, if you are risking specific amounts of capital like in the example above, versus trading fixed lots, then you will be adjusting dynamically with S&P 500 volatility. For more on the topic of risk management, check out this article and video on sound risk management techniques.

S&P 500 VIX & ATR (Changing volatility requires changes to trading size)

As volatility changes (ATR/VIX) so should position sizes

S&P 500 and VIX Key takeaways

To summarize, understanding stock market volatility and the CBOE Volatility Index (VIX) is important for trading equity indices. There are benefits to understanding the nature of volatility from both an analytical and risk management standpoint. Like all things, getting a feel for the relationship between the VIX and the S&P 500 will take a little experience to get a handle on, but well worth the time.

For more information on the S&P 500 Index, read our guide to trading S&P 500. Or for an in-depth review of the major stock indices, we have rounded up the top differences between the Dow, Nasdaq and S&P 500.

For fundamental and technical views on the S&P 500 and other major indices, see the DailyFX Quarterly Equities Forecast. You can also sign up to one of our free daily webinarswhich are specifically geared towards equity markets.

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

DISCLOSURES

News & Analysis at your fingertips.