The fear index, or as it is called in another way the volatility index, is one of the main tools of traders. Used to receive market signals. It is used in most trading strategies, but, unfortunately, not everyone has a full understanding of what it is. In this article, we will tell you what the volatility index is and how to use it.
WHAT IS THE VOLATILITY (FEAR) INDEX?
The volatility index determines the level of fear of investors about the dynamics of the instrument’s price. It is usually measured as a percentage.
Simply put, the volatility index is a measure of investor sentiment. They are built on relatively large stock indexes, reflecting the state of the largest strata of the stock market. If the majority of investors are confident in the stability of the market situation, the volatility index is low. In the opposite case, when investors expect high price dynamics in the market, then this index, accordingly, reaches its maximum values.
At the moment, there are only a few major fear indexes, consisting of different underlying assets. All of them originate from the Chicago stock exchange SVOE, which back in 1993 created the VIX volatility index (from the English Volatility Index).
Planning for the creation of this index began in 1986, but its calculation was delayed as much as 7 years. Initially, the index was based on an option from the key US indexes S & P100. Since 2004, the VIX has been calculated based on the volatility of the S & P500 index, since it is one of the largest and includes a huge number of securities of different companies. This allows us to cover a significant segment of the market.
It is important to clarify that the calculation of the volatility index on the S & P100 continues, but already under the ticker VXO.
The S & P500 index itself and the volatility index calculated on its basis have an inverse correlation. This means that the highest points on the S&P 500 price chart coincide in time with the lowest points on the VIX chart. It depends on the expectations of high price volatility on the part of market participants. The moment changes are minimized, the market becomes predictable. This, in turn, affects the rise in prices for financial instruments. It cannot be said that this dependence is permanent, but in most cases the correlation is quite pronounced.
What does the volatility index depend on?
The volatility index directly depends on the expectations of traders. They base their expectations on many factors. These can be:
- Release of important news
- Breaking trends
- Crisis phenomena
During a stable trend movement, a low value of the volatility index is characteristic, as market participants expect it to continue.
How the index VIX is used
There are certain critical limits of the index, the exit from which is regarded by market participants as trading signals.
- Less than 20% – Low volatility, which is typical for high market optimism. The lower the value, the more likely it is that the trend will reverse in the near future. This VIX value suggests that it is worth selling stocks, closing deals and taking profits before the tipping point.
- 20% – 30% – Average. Neutral meaning, incapable of giving any specific signals
- 30% – 40% – Considered to be an increased level of volatility. It characterizes the period before the crisis or serious price changes.
- More than 40% – Panic in the market. This volatility is accompanied by a collapse in stock prices from the S&P 500 list. It is a signal to buy these stocks. As soon as the volatility value declines again, the stock returns to its price. Knowing this, many traders buy stocks during a crash and sell when the market stabilizes.
VIX ANALOGS – LIST OF REMAINING VOLATILITY INDEXES
At the moment, there are a huge variety of all kinds of volatility indexes. These are:
- VXST – VIX , calculated with a nine-day volatility period;
- VIXY – short-term index futures on the NYSE;
- VXD – DJIA Volatility Index – according to the Dow Jones 30;
- VXN – Nasdaq index;
- RVX – Russell 2000 Volatility Index;
- VXEEM – Emerging Markets ETF Volatility Index;
- VXAZN – Amazon stock volatility index;
- VXAPL – Apple stock volatility index;
- VXGOG – Google stock volatility index;
- SRVX – Interest Rate Swap Volatility Index (index per rate);
- EVZ – EuroCurrency ETF Volatility Index (euro volatility index);
- OVX – Crude Oil ETF Volatility Index (oil volatility index);
- GZV – Gold ETF Volatility Index (gold volatility index);
- RVI – Russian market volatility index.
Advice and Conclusions
The head of research at Afex Capital provides the following advice for working with volatility indexes:
- Don’t take an abrupt change in the index as a call to action. It is necessary to choose wisely which movements of the index should be regarded as signals.
- Use derivative financial instruments. It is not necessary to acquire the underlying asset of the index to earn money. You can buy a derivative that is close to the volatility index.
Today, the fear index is a rather controversial tool. Taking into account the correlation dependence of the index with its underlying assets, an understanding trader can correctly determine the correct entry point.
If, however, you are a beginner trader, then we advise you to seek help from an expert.