The Volatility Index better known as “The VIX” can arguably be called the swiss knife of trading tools.
The VIX is a risk meter, market sentiment indicator, and fear gauge all wrapped up in a single value and holds tremendous value to those who trade off information like this.
And with Daily Deposits I use this indicator to zone-in on the direction of the markets
Combined with my pre market momentum analysis, I get a complete picture of what I can expect the upcoming trading day to look like.
So I’m going to teach you how I use the Volatility Index (VIX) for timely and actionable signals… and to help get any edge I can against the markets.
The strategy used at Daily Deposits is to predict the direction of the markets.
Well I am not a fortune teller, but I simply use clues found from a proprietary set of pre market momentum indicators that give me an idea of which direction the markets are going to go in.
And when analyzing the pre markets, one of the non-traditional indicators I always keep an eye on is the VIX, or Volatility Index.
The way that I see it… the VIX is more than a fear gauge of the market. I like to think that it gives me a head start on the direction the market is taking.
Personally, it’s one of my personal favorite indicators to trade with that I make sure to keep on my screen at all times.
Now I know that you may have never heard of the VIX…and that’s ok!
In this article I want to review what the VIX is and how I use it to trade the S&P 500
What is the VIX?
The VIX is a symbol for the Chicago Board Options Exchange’s Volatility Index.
What is it?
The volatility index is a measure of the implied volatility of all of the options in the S&P 500.
Now, you may have heard of this indicator by other names, such as the VXX, “investors fear index”, or “the fear gauge of the markets”… just to name a few.
The VXX is a complex spread of the futures symbol, VIX. This is similar to the stock markets, USO and the crude oil futures.
Note: I will review the VIX and how it applies to gauging the fear of the SPY, not the VXX due to various factors that can influence its pricing.
Here’s an example of what the VIX looks like on a daily chart.
And here is an intraday view of the VIX as well using a 5m chart.
I know this might not look like much, but let’s take a deeper look at what the VIX represents for a trader.
How To Read The VIX
The VIX represents the market’s best prediction of near-term market volatility.
This value is the indication of volatility expected by the option’s market which lets investors know if they should experience stability or turbulence in the near term in the markets.
And there are many ways a trader can use this information for their trading.
- VIX > 20 : markets are in a risk-off market environment
- VIX < 20 : markets are in a risk-on market environment
Next, let’s take a look at how to read the VIX if it’s reporting a 80% reading.
For example, if the VIX is reading 80, or 80%, it means that the market is pricing in an annualized movement of nearly 7% over the next 30 days.
Ok – so that might have been confusing… Let’s break it down a little further.
A value of the VIX indicates that the SPY is priced to move 6.67% in either direction over the next month.
This is calculated by taking the value of the VIX and dividing by 12 to give you a 1-month average.
In this example, you will have 80% / 12 months = 6.67% movement of the SPY priced in by the VIX in the next 30 days
Note: This is a general movement up or down. There is no indication (yet) of the movement being higher or lower without analyzing the VIX further.
How To Apply The VIX To The SPY
One way to look at this indicator is as an inverse to the SPY. If the VIX rises, the SPY will fall.
This gives an interesting view of the markets and provides traders with information about the direction of the markets typically before the move even happens.
Here is an example of the SPY and VIX overlapped with one another.
And when looking at this chart, you can easily see this pattern where the SPY dips and the VIX rips.
This means that investors are fearful and that they are leaving stocks as the prices drop lower and causing the VIX to spike higher.
But just because the VIX is elevated doesn’t mean to go short the markets. In fact, sometimes the opposite is true.
Now … let’s take a look at how to use this to predict the direction of the markets.
Reading The VIX
As we already covered, it’s common to hear the VIX called the “fear gauge” of the stock market.
Basically this indicator says, When the values of the VIX are high, investors are more fearful compared to when values of the VIX are lower.
But… are there price predictability powers that are built into this indicator?
In short, absolutely!
By keeping a real-time VIX on your screens when considering entering a trade gives you a look into the feelings the entire market is having toward the price action.
Here are 5 key ways to analyze the VIX for signals to trade the SPY:
1. Rising VIX + rising S&P 500:
Bearish divergence that predicts shrinking risk appetite and high risk for a downside reversal.
2. Rising VIX + falling S&P 500:
Bearish convergence that raises the odds for a downside trend day.
3. Falling VIX + falling S&P 500:
Bullish divergence that predicts growing risk appetite and a high potential for an upside reversal.
4. Falling VIX + rising S&P 500:
Bullish convergence that raises odds for an upside trend day.
5. Divergent action between S&P 500 and the other index futures:
lowers predictive reliability. This often yields choppy price action or whipsaws, confusion and range bound conditions.
From swing trading to intraday divergences, there are many ways to view the VIX and the signals that it gives to you every day.
Even though there are some ups and downs in the price of the VIX, the general trend lately is still pointing to markets heading higher.
While the tale of the VIX is scary, relentless, and terrifying – especially when markets are in turmoil… It is actually a great forward-looking indicator.
And if properly used, it can give a trader the heads up to what the overall market feels and gives clues of what the movement might be for the days ahead.