In-depth Analysis

Is it time to trade the VIX?

It is stating the obvious that the volatility in the market is becoming almost uncomfortably high but one way of making use of it is to trade the volatility itself. The Chicago Board of Trade Volatility Index has risen by 77% since the start of the year which has been rich with trading signals: conflict in Ukraine, sanctions on Russia, waves of Covid lockdowns in China, rising gas, oil and fuel prices, and now repeated interest rate hikes.

As US stock markets plunge and markets flirt with recession, the VIX index which has a strong negative correlation with stock markets offers the counter trade, an option to hedge against the declines. The S&P 500 has recently moved into a bear market, meaning that it has lost at least 20% from a recent peak. The Nasdaq has fared even worse, trading down 30% since the start of the year and trading in bear territory for a longer period already.

The index, also called the “Fear Index”, is calculated from weighted puts and calls prices based on the S&P 500, it is forward looking and short-term, showing the implied volatility of the S&P500 for the next thirty days. The strong negative correlation of VIX-linked instruments and the stock market has made them a popular choice among traders and investors for diversification and hedging, as well as pure speculation.

Technically, the index only measures the volatility of the S&P 500 index, but it is used as a benchmark for the broader US market. This also means that domestic US events, such as Fed interest rate decisions, will carry a heavier weight than international events.

The index started the year at 16.6, rallied to 31.96 by the end of January, dropped to around 20 in February and spiked again to 35.45 in March. In May it traded in a relatively narrow band between 35 and 29. Interestingly, even with all the current uncertainty in the market, the VIX level is far below what it was either during the financial crisis in 2008, or in 2020. After the onset of Covid in 2020 the VIX hit a historic high of 82.69, surpassing the 80.86 level reached at the peak of the crisis in 2008.

Historic context

The index’s long-term average is around 19.5 with a VIX reading below 20 implying that the trading environment is relatively low risk, and a reading above 20 indicating a period of high risk. It has fairly well-defined support and resistance levels, and it very infrequently breaks below 10 or above the resistance level at around 50.

The resistance level has only been breached in a few situations – in 2008, 2009, 2015, 2018 and 2020. In the first four years the break above 50 only lasted for one trading session at the time and only in 2020 did the VIX stay above 50 for about one month.

US data will provide fresh signals

In the weeks ahead some of the main signals for the VIX will come from US economic data and the Federal Reserve’s rate decisions. US GDP decreased at an annual rate of 1.4% in the first quarter of this year and if it contracted again, it would signal a recession but this is not a given as a survey by the Federal Reserve Bank of Philadelphia forecasts a 2.3% growth in the GDP this quarter.

The only thing that seems certain is that the volatility will remain high for some time to come.

 

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