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Investor: Trading The Volatility Index (VIX)

The Volatility Index (VIX) is something every trader and advanced investor monitors. It is a measure of fear in the overall market. When it falls, there is little fear in the market and when it rises, fear, market anxiety is rising. Historically, the VIX tends to fall to 10 or slightly below in times of robust optimism and greed. During fear an panic, it can rise above 30. During the financial crisis of 2008 and 2009, it went well above 50.

Investors and traders pay attention to the volatility index (VIX) because it gives them  a sense of overall market complacency. For example, it can tell them when to sell their longs. A smart investor or trader would likely sell some of their long holdings inside their portfolio if the VIX dipped below 12. They would continue to sell if the VIX fell down to 10. Below 12, many investors would even start to accumulate short positions. Fear rising (the VIX rising), likely means the market is falling. The VIX below 12 likely means the markets are extended to the upside and greed is maxing out.

One of the nice things about the VIX is that it tends to move in mega sized increments. When fear strikes, the VIX can easily go from 10 to 20 within a few days. This gives traders the ability to make big money on a small position.

Many traders and investors use the VIX as a hedge against their long positions. For example, if an investor is heavily long and knows the market is overbought, they may buy the VIX to protect themselves in case the market falls sharply. While they may lose a little money on their long stock positions, they will recoup some of it on the VIX when it spikes dramatically higher.

In many ways, the volatility index (VIX) is an indicator of greed and fear. Since the markets top on excessive greed and bottom on insane fear, the extremes of the VIX are very useful for investors.