Here in this article I will explain you VIX definition, history, calculation and its trading strategy.
VIX Definition
In order to measure the bearish or bullish nature of the broad market traders use VIX or volatility Index. In order to do this VIX measure the implied volatility of the S&P 500 index options. The expected volatility of the market is displayed by VIX in 30 days out in the future.
It is believed by the traders that the VIX is a good indication of the fear in the market. This is due to the reason that if the VIX reaches extreme levels, then this means that a number of traders have purchased puts as insurance against a falling market.
History of the VIX
In 1993 a professor at Duke University Robert E. Whaley first published VIX. He was able to create the first index that can be used to track the volatility which is associated with underlying exchange traded futures and options.
Calculation of VIX
In order to calculate VIX, 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 are analyzed.
VIX vs VXO
In 2003, the VIX went under a major algorithm change. Originally in order to calculate VIX the implied volatility of the at the money options of the S&P 100 were measured using the Black Scholes Model and was known as the VXO.
Due to the fact that VXO was based of a small number of issues and not reflective of the market at large so it had a number of faults. This issue has been corrected by VIX by basing it of the S&P 500, which is a better representation of the market.
VIX Trading Strategy
The VIX does not resembles an oscillator, so in theory it has no cap on how high it can go. A basic rule of thumb is that if VIX moves above 30 then this indicates increased volatility. Conversely if VIX has a reading below 20 then this indicates a passive nature in the market, with little to know volatility.
The traders were not following VIX 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 as compared to their rise, so bear market moves usually terminate with a high VIX reading.
A basic trading strategy is that when the VIX indicator is over 40 then the trader has to look for a fire sell in the broad market. Recently on October 10, 2008, the VIX reached an intra day high of 75.92 but this extreme reading was a result of the most volatile trading week in U.S. History.
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Posted by R. MAK. in Stock Trading · 0 Comment
