What is the VIX and how do you trade it?

Please note: the values in this chart should be viewed as representations only and should not be taken as accurate VIX Index figures for the stipulated time periods.

The VIX is calculated using the prices of SPX index options and is expressed as a percentage. If the VIX value increases, it is likely that the S&P 500 is falling, and if the VIX value declines, then the S&P 500 is likely to be experiencing stability.

What does the VIX measure?

While the VIX only measures S&P 500 volatility, it is commonly used as a benchmark for the entire US stock market. The price of options is considered a good measure of volatility as if something concerns the market, traders and investors tend to start buying options, which causes prices to rise. This is why the VIX is also known as the fear index, as it measures the level of market fear and stress.

The current volatility cannot be known ahead of time, so the VIX is best used in tandem with historical analysis of support and resistance lines.

Why trade the VIX?

VIX-linked instruments have a strong negative correlation with the stock market, which has made them a popular choice among traders and investors for diversification and hedging, as well as pure speculation.

By taking a position on the VIX, you could potentially balance out other stock positions in your portfolio and hedge your market exposure.

Let’s say that you have a long position on the stock of a US company that was a constituent of the S&P 500. Although you believe it has long-term prospects, you want to reduce your exposure to some short-term volatility. You decide to open a position to buy the VIX with the expectation that volatility is going to increase. By doing so, you might balance out these positions.

If you were wrong, and volatility didn’t increase, your losses to your VIX position could be mitigated by gains to your existing trade.

Remember, with us you can only trade derivatives via CFDs.

How do you calculate and trade the VIX?

1. Research how the VIX works
2. Choose whether to trade CFDs
3. Decide whether to go long or short on the VIX
4. Open a live account or practise on a demo

Research how the VIX works

The VIX works by tracking the underlying price of S&P 500 options – not the stock market itself. Below you’ll learn what S&P 500 options are, how the VIX is calculated and what its value means.

The calculation of the VIX involves extremely complex mathematics, though it isn’t necessary for every trader to understand this in order to trade the index. However, the basic theory of the calculation is that by combining the weighted prices of multiple S&P 500 put and call options over a wide range of strike prices, we can gain insight into what prices traders are willing to buy and sell the S&P 500 at. These final values will estimate the future volatility of the S&P 500.

The options that qualify for inclusion will be at the money so that they show the general market perception of which strike prices are going to be hit before expiry. This then indicates the wider market sentiment surrounding the direction of the market price.

Choose whether to trade CFDs

CFD trading on the Volatility Index

When you trade the Volatility Index with CFDs, you are agreeing to exchange the difference in price from when you opened the position to when you close it. The more that the Volatility Index moves in the direction that you have predicted, the more you would profit and the more it moves against you, the more you would lose.

CFDs are liable for capital gains tax, but you can offset your losses against profits elsewhere for tax purposes.²

It is important to note that CFDs are complex instruments and your losses or profits could outweigh your initial deposit amount due to leverage. You should also take steps to manage your risk.

Decide whether to go long or short on the VIX

When you trade the VIX, there are two basic positions that you can take: long or short. It is important to remember that volatility traders aren’t interested in whether the price of the S&P 500 is going to rise or fall, as they can capitalise on both – they’re instead looking at whether the market is volatile.

Going long on the VIX

The position you decide to take will depend on your expectation of volatility levels. Traders who go long on the VIX are those who believe that volatility is going to increase and so the VIX will rise. Going long on the VIX is a popular position in times of financial instability, when there is a lot of stress and uncertainty in the market.

For example, if you thought that the S&P 500 was going to experience a significant and rapid decline following a political announcement, you might take a long view of volatility. You could do this by opening a position to buy the VIX.

If there was volatility, your prediction would have been right, and you could take a profit. However, if you had taken a long position and there was no volatility in the market, your position would have suffered a loss.

Going short on the VIX

When you take a short position on the VIX, you’re essentially expecting that the S&P 500 is going to rise in value. Short-selling volatility is particularly popular when interest rates are low, there’s reasonable economic growth and low volatility across financial markets.

Let’s say that the combination of low volatility and high economic growth had led to steady growth in the S&P 500 constituent’s share prices. You might decide to short volatility with the expectation that the stock market will keep rising and volatility will remain low.

If the S&P 500 does rise, then the VIX is likely to move to a lower level, and you could take a profit. However, shorting volatility is inherently risky, as there is the potential for unlimited loss if volatility spikes.