The often referenced and too often misunderstood measure of the stock market’s volatility, the CBOE Volatility Index (ticker symbol “VIX”), is important because it tells you something about traders’ and investors’ psychology – mostly how afraid they are.

That’s why the VIX is also known as the fear index.

The VIX is calculated from prices traders and investors are paying for put and call options on the S&P 500 index (ticker symbol “SPX”), an index of 500 large-cap stocks traded on major U.S. exchanges that institutional money managers and Wall Street analysts collectively call “the stock market.”

Mechanically, in real time, updated every 15 seconds, actual prices paid for puts and calls on a wide range of SPX strike prices, with expirations between 23 and 37 days out, are aggregated and weighted to yield a constant maturity 30-day measure of expected volatility.

On the surface, the VIX is an index, but underneath it’s a measure of something called implied volatility, which I’ll explain in detail here in a moment.

Despite its nickname, you don’t have to be afraid of the VIX at all – in fact, it can be one of the most powerful tools in your arsenal to make money in both calm and volatile markets.

I’m going to show you how it works, what it’s saying now, and exactly how to play it.

Implied Volatility
What the VIX is measuring underneath the prices paid for options is implied volatility. Implied volatility is (hence the name) what’s implied in the price of options, by what investors are willing to pay for those options. The more they’re willing to pay, for puts as an example, the more volatility they expect. More future volatility is implied by higher prices paid.

Typically, the more investors pay for puts on the S&P 500, because they’re paying up for downside protection or to bet on a downside move, the higher the VIX goes.

That’s why it’s a called the fear index.

The long run mean of the VIX is 20. That’s the average level since 1990.

In up-trending markets, especially bull markets, the VIX can trend down to 15, 14, 13, 12 and lower. The all -time low for the VIX on an intraday basis was 8.56 on November 24, 2017. On a closing basis the low was 9.19 on November 3, 2017.

On the high side, the highest the VIX ever got on an intraday basis was 89.53 on October 24, 2008, but don’t think only 2008 saw those kinds of VIX levels; March 16,17,18 and 19th of 2020 saw the intraday VIX spot go from 83 to 85.47. On a closing basis the highest close on the VIX came on March 16, 2020 at 82.69.

The highest close in the 2008 financial crisis was 80.86 on November 20, 2008.

Here’s what those numbers mean in context.

Reading the VIX: Mean and Standard Deviation
The long-term mean of the VIX, as I said, is 20. That’s important as a benchmark because we measure the VIX’s volatility in terms of standard deviations away from the mean.

In statistics, a standard deviation is a measure of distributions, or how far from the mean values tend to vary. In most distributions, about 95% of values will be within two standard deviations of the mean.

One standard deviation on the VIX is 8. With the mean being 20, a one standard deviation move would be to 28, a two standard deviations move would be to 36. Three standard deviations, a big move, would put the VIX at 44, four standard deviations is 52, and so on.

An 89 print, which the VIX saw intraday during the financial crisis, was an 8 standard deviation move.

In up-trending markets, especially demonstrable bull markets, a low VIX that is trending lower (for example, an 18 print trending lower from 18) is a sign of complacency and market calm, which is a clearing for stocks to trend higher. For this, the direction or trend of the VIX is more important than the VIX level itself. That’s when you should be adding to your long positions, playing the market from the buy side.

On the other hand, when the VIX is trending higher close to one standard deviation up from its mean, to 28, it’s time to tighten up your stops and be more cautious.

That’s especially true when the VIX is moving faster towards a 2 standard deviation move at 36, which can happen quickly. If you don’t already have your stops in place after seeing the VIX trend upward to 28, you better move quickly because in a down-trending market, with any panic selling, the VIX can jump, which tends to scare investors into quickly selling more.

How to Trade the VIX Right Now
Given the kind of market we’re in here in September 2022, with the Fed raising interest rates, inflation running hot, potential peak earnings behind us, and the VIX having hit 1 and 2 standard deviation moves over the past couple of months, using the VIX to gauge market risk is even more important because the inherent volatility in this kind of a market is tradable, at least on a short-term basis.

My statistics, as well as work by other analysts I follow, shows that this kind of market – a bear market where we’re seeing quick upside moves, especially around and in front of options expiration dates (in other words, bullish pops in an otherwise bear trending market) can be played easily.

By the time the VIX gets to 36, which you should have been prepared for and maybe stopped out of many of your positions with profits or small losses, it’s generally a time to take on some risk and ride the VIX down and markets going higher for a while.

If the VIX gets to 44, a 3 standard deviation move in this kind of flip-flopping market, that’s generally a very bullish signal and time to make some serious upside bets, especially on indexes.

I like buying out of the money calls on index ETFs like SPY and the QQQs when that happens. That limits my risk and sets me up for potentially quick and meaningful gains if the VIX falls back and stocks rebound.

If the VIX’s trend is more defined to the upside, meaning it stays elevated, it’s better to take less risk and see how high it goes. In panicky markets with outright fear selling, the VIX can skyrocket.

Understanding when that happens and why it’s happening is very important, because if you see the VIX hit 4, 5, or 6 standard deviation moves higher, you’re definitely getting close to a major league buying opportunity. Because that kind of panic selling always, and I do mean always, means a market low is coming soon and you want to buy stocks and the market when it’s cheap.

But in the kind of market we’re in now, choppy and bullish pops in a bear market, a 20 print on the VIX after it’s fallen from a two standard deviation move higher is probably a good time to take your profits or lighten up on what you bought, ahead of the VIX likely rising again amidst more selling.

That’s how I use the VIX in volatile markets to trade, mostly market benchmark index ETFs including leveraged ETFs.

You can also trade the VIX itself.

There are lots of ways to play the VIX’s moves up and down, but my favorite is buying calls and puts or call spreads and put spreads on the actual VIX, not on VIX futures.

In this kind of market, if the VIX gets to 20 or lower, I like buying call spreads on the VIX.

When the VIX moves towards 2 standard deviations higher, I immediately buy put spreads.

I don’t go more than 30 to 45 days out on my expiration dates, and sometimes I’ll go half that, depending on the severity of a move. And I use 20 as a baseline and trade strike price levels above and below 20 especially those 1, 2, and 3 standard deviation moves.

That’s how you can make money trading market volatility directly, by trading the VIX.

So, go ahead, get friendly with volatility, especially the VIX, and use it to trade against and trade it.

— Shah Gilani

Source: Total Wealth Research