The Fear Gauge – Using The VIX Index Successfully
The VIX Index is also referred to as the ‘fear gauge’ because it measures implied volatility. Although it doesn’t actually measure the mental states of investors, a rising VIX Index is a sign of expected financial turmoil and market instability, which is usually accompanied by investor panic. There are several ways that you can use the VIX Index to help you make informed investment decisions.
What The VIX Index Means
If the VIX Index falling and is relatively low compared to recent levels, this shows disinterest in the market and market is said to be in a low volatility environment; there’s contentment among investors in the way the market’s moving. When the VIX Index really matters is when it rises above recent levels. A low VIX Index means investor complacency; but the rising VIX shows fear. If it’s rising, this means that there is a potentially big market turnaround coming. Shifts in the VIX Index may also represent the beginnings of new trends in the market.
Reading The Market
First, it’s important to understand that in times of market stress, put option premiums rise. You can think of a put option as an insurance policy. It protects you from market downturns. In just the same way that insurance premiums rise following negative events, put option premiums also rise. This can be very important for you as an investor, whether you’re holding put options or thinking of investing in them.
This may be surprising, but during times of high volatility, call premiums also rise, but not as much as the puts. This goes contrary to what many investors would expect. However, both put and call option premiums are closely related to market volatility. By keeping an eye on the VIX Index, you can see clearly when option premiums are going to rise and use this to make informed investment decisions.
Trading VIX Derivatives
Although you can’t trade on the VIX directly, there are VIX derivatives that allow you to trade indirectly without having to own the actual stock. Few investors take advantage of this option, but it can be used for generating great profits.
VIX derivatives that you can trade include VIX options, VIX futures, and VIX ETFs. VIX options include both standard and binary options. VIX futures can be traded in contract sizes of either 100 times or 1000 times the VIX. Contract sizes of 100 times were introduced in recent years to allow smaller investors to add volatility exposure to their portfolios (the price of 1000-times contracts is prohibitively high for many investors).
VIX ETFs can be traded as one-month VIX futures or five-month VIX futures. These ETFs were introduced by Barclays in 2009 in order to track futures contracts’ prices on the VIX Index. This makes it much easier for retail investors to add volatility exposure to their portfolios.
There Is Always Risk
Although exposing your portfolio to volatility using the VIX Index helps you by hedging against market fluctuations, you should keep in mind that there is always some inherent risk. Before you make important investment decisions, make sure you’re aware of what this can mean for you.