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VIX - Fear Index. Who and how makes money on the nervousness of investors?

Investors always want to anticipate price movements. To do this, they use different methods with varying degrees of scientificity and usefulness. One way is to use leading indices, which include volatility indicators.

The most famous of these indicators is the VIX Volatility Index of the Chicago Board Options Exchange. It is also known as the Fear Index.

How the VIX Fear Index works

Analysts and investors using the VIX believe that it measures market sentiment regarding future volatility. In other words, this index demonstrates the level of investors' fears about future market movements.

Knowing the degree of investors' fears now, one can assume in which direction the aggregate investor sentiment will direct the quotes.

How are these fears measured? The main idea according to which the volatility indicator is used is that the indicator is calculated based on the prices of options. Therefore, to understand how it works, you need to understand how an option works.

What is an option

An option is a specific exchange contract that gives the investor who bought it the right to buy or sell afinancial instrument at a certain price. In a classic exchange transaction, it is about duty, not right.

Because of this property, the option is often used for market investment insurance. How is this achieved? Let's see how options are used using oil as an example.

SPX500 Option: Calculation Example

Suppose a trader buys index ETF SPY (exchange trade fund related to SP500) at a price of $ 400, at the same time an investor buys aPUT option to sell SPY at $ 400 (the strike price of the option), paying a certain amount for it - the option premium (OP). Let the OP will be $20. With this right, the trader insures his investments in case the price falls.

If the SPY price rises to $500, then the trader will receive $100 from each lot SPY. After subtracting the OP in the amount of $20, the investor's net profit is $ 80.

But if the price of SPY falls to $ 300, then the trader can exercise the right that the option gives him and sell his oil at $400. Then the investor will only lose what he paid for the option - exactly $ 20.
 

CALL option works in the same way as a PUT option, but unlike a PUT option, CALL options insure investors against an increase in the price of the underlying asset. The CALL option is used when using various trading strategies.

VIX index calculation. How it works.

VIX index uses the prices of options on the S&P 500 index for calculation. Thanks to ETFs and futures on the S&P 500 indexes, to some extent, has become anexchange product itself.

The more investors fear a market decline, the more PUT premiums rise and call premiums fall. On the contrary, if the market is confident in growth, then premiums for CALL options will increase, and premiums for PUT options will decrease.

But if the market is not sure about the direction, then most of the participants are afraid of unforeseen movements and hedge against them. This will show an increase in the premiums of all options - both PUT and CALL. The index is calculated in such a way that the larger the premiums, the larger the VIX.

Fear scale from 0 to 100

The VIX index is in theory on a scale from 0 to 100. The index has been calculated since January 1990. The index reached its maximum in history of 89.53 points on October 24, 2008, and the minimum - 8.56 points - on November 24, 2017. Most often, the indicator values are in the range from 15 to 40.

If the value of the indicator is below 20 or 15, then investors' fears about the market fall are not great. This means that the markets are in an upward trend in the medium and long term. The very decline in VIX below 20 can be taken as a reason to think about buying American securities in the long term.

If the indicator value exceeds the level of 70–80, then theoretically this should mean that traders are trying to insure themselves as much as possible. Moreover, not only from fluctuations, but also from the deep fall of the market.

After the indicator peaked in October 2008, the US indices continued their decline, reaching a bottom in March 2009. It should be noted that in practice the indicator took values above 50 in its entire history only from October 2008 to March 2009 inclusive. Therefore, in practice, it was no longer possible to use it to predict entering a downtrend.

Most often, traders prefer to focus on the upper limit of 45. Finding the indicator above 45 means that the level of fear in the market is high enough and it is worth refraining from buying for now. However, overcoming these levels should not be taken as a signal to sell.

If you hold liquid American stocks in your portfolio, then the signal for the start of selling may be the VIX exceeding the value 20. In addition, it is worth watching the local lows of the volatility index.

When the next local minimum of the index turned out to be higher than the previous value and at the same time the corresponding new values of stock indices (Dow Jones and NASDAQ) are higher than the values on the date of the previous local minimum of the VIX, then this is the so-called divergence - divergence. In such cases, many investors close part of their long positions.
 
How the volatility index is bought. VXX and its other derivatives.

Investors often use the index to hedge their portfolios and protect them from deep drawdowns and reduce portfolio volatility. These strategies are based on different ways to determine the best moment to buy the volatility index. The index itself is not traded, and in order to open a position in the volatility index, traders’ resort to buying futures or buying ETFs, which are based on futures on the volatility index.

The most popular tool that allows you to open a position in the volatility index is ETF VXX, and traders actively use it when implementing a variety of trading strategies.

The most popular technique for trading VXX is to systematically sell it in order to capitalize on the fall in the value of the fund due to contango exposure. It is contango that is the very insidious feature of volatility index futures, which makes trading them extremely difficult for successful implementation.

Another volatility trading trick is to open long positions in VXX to exploit short-term fluctuations in the fund's value, which are associated with the rapid manifestation of negative events that allow the Fear Index to reach values above 45 points. Predicting such events is an extremely difficult task, and traders use their proprietary techniques to increase the likelihood of predicting adverse events in the US stock market and the time periods when the fear index peaks.

You can read more about contango at the link - What is contango.

Traders who use the volatility index in their trading algorithms

ETORO SPXHEDGEFUND

*The material presented in the article is not an investment recommendation. Investments involve risk and should be based on a comprehensive analysis of investment decisions in accordance with the investor's risk appetite and specific characteristics of the instruments. Contact your financial advisor for risk assessment and investment strategy development.

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