Understanding the CBOE Volatility Index (VIX)

Definition: The Volatility Index, or VIX, is a real-time market index that represents the market's expectation of 30-day forward-looking volatility. Derived from the price inputs of the S&P 500 index options, it provides a measure of market risk and investors' sentiments.

What does this mean to us as individual investors and traders, and how can the Volatility Index - the VIX help us make money?

As chart readers, our primary focus using technical analysis is if prices are going up, down, sideways, and where they are likely to change direction.

The Volatility index does move up, down, sideways, and does change direction.

However, it moves in the opposite direction of the broader markets – most of the time. So, the times that it does not will provide valuable information.

Why Does VIX Go Up When the Market Goes Down?

When the market goes down, investors want to purchase insurance to protect/hedge their portfolios from loss using options, which drives up the prices of put options (bearish bets) and increases the VIX.

The VIX decreases when there's less demand for put options as the market rises.

That's why it tends to move inversely to equities.

Knowing how and why the VIX moves, you can understand why it is referred to as a Fear Gauge at times.

As the market falls, the Volatility Index rises – we know that.

But how much will it rise? If it is low, is it too low, and is that a concern?

As you can see from the above chart of the Volatility Index (VIX), it can move wildly up and down in broad ranges.

I provided a chart to give you a historical perspective of high and low.

The high extremes are useful to be aware of during periods when the market sells off a significant amount. Luckily, those times are few and far between.

You can see that what is considered low can stay low for a long time.

So, just being low doesn't mean that the Volatility Index has to go up.

Interpretation of Movements in the Volatility Index

For investors and swing traders, the most recent data over the last year or two to display the Volatility Index recent highs, and lows is going to be the most useful.

Also useful is whether the VIX is trending up or trending down.

If the VIX is trending higher, we want to take note of what the most recent peak high was.

Do do that by merely looking to the left.  No indicators needed.

The price level that VIX fell from before is an excellent guide where it may fall from again. 

Looking to the left is a simple and effective concept to find turning points.

That reference point in the VIX from the past is then used to determine where the markets will likely rise from when the VIX reaches the area of the prior turning point.

Since the S&P 500 and VIX move inverse to each other, how is VIX useful?

If we're looking at a chart that moves in the opposite direction? Good question!

There many times in history where the markets were falling, and there was no market price support to the left.  

Meaning, no market support could coincide with the resistance to the Volatility Index.

The reference point provided where the Volatility Index had been was an excellent guide as to when the markets would reverse their move lower.

In the chart above, the S&P 500 ETF symbol SPY is above the Volatility Index.

In March 2020, the markets were falling sharply and broke through the prior swing low on the monthly time-frame.

The next reference point of price support was significantly lower; however, the prior high in the Volatility Index is to the left.

Based on prior analysis of VIX turns at its prior high area and market turns, the market turn was close.

As you can see, the past spike in the VIX index coincided with the S&P 500 being is close to a turning point in its move lower. The same happened in 2020.

You can also see between those two spike points that there were many times where the Volatility Index reached peaks and fell in the markets made a bottom.

Using the Volatility Index for Intra-day Guidance

The chart above shows the S&P 500 ETF and the Volatility Index below on a five-minute intraday time-frame.

On that day, the broader markets were falling continuously throughout the day.

The VIX would rise as the markets fell, confirming that an increase in put options (bearish bets) were being bought, and that would subside as the market rose.

As the S&P 500 continued lower, the VIX moved higher toward the prior high.

When the S&P 500 broke down below the prior swing low, the VIX did not make a new high. The VIX might have continued to move higher, but it did not, it stalled.

That stall gave intra-day traders a "heads-up" that the markets were likely to turn up.

With that in mind, it was time to cover a short position and consider buying.

I need to mention that it is the S&P 500 was the focus to trade here, not the Volatility Index.

If interested, we could trade the Volatility ETF symbol VXX.

Add the Volatility Index to Your Technical Toolbox.