Generate Income Trade Options
Using the VIX as an indicator
What is the VIX? The VIX or Option Volatility Index is a measure introduced by the Chicago board of options exchange (CBOE), it is an index that measures how volatile the market is expected to be in the next 30 days! (It measures the premium of the OTM options offered on the S & P 500 stock index)Now this VIX indicator measures the expected volatility for the S & P 500 stock index, which fully represents the state of all US stock markets and even European stock markets, it is even considered to be a benchmark for the entire US economy. The lowest the VIX has ever been was 9.31 and the highest was 89.53, most of the time it trades between 15 and 30-35. When the VIX has a reading of say 30, that is the annualized expected volatility for the next 30 days. The actual expected volatility for the next 30 days will be according to the formula 30/√12=8.66 So this means that a VIX reading of 30, implies that traders believe that the S & P 500 could move 8.66% up or down in the next 30 days!
Now volatility has the tendency to increase as markets fall, and it decreases as markets rally, this is due to the fact that markets fall much faster than they can rise, so since VIX moves counter to the S & P 500. We know that we can use it as a measure to assess traders fear or confidence. A low VIX reading means that traders are confident and markets rally, a high VIX reading indicates traders are nervous. However because this VIX volatility and confidence/fear indicator is a mean-reverting indicator, it has the tendency to revert back to its moving average in the end. It deviates from it for few days, then it usually but not always, reverts back to the average.
The idea of using this indicator is to measure where it stands relative to its 10 day moving average. Once away from the average two things can happen, either the 10 day moving average will move towards the price of the VIX (Rare event), or the VIX will move back to meet its 10 day average (Frequent event), more often than not, the VIX moves back to the average. And if the VIX is about to make this move in one direction, then the S&P 500 will move in the opposite direction!
The VIX relative to its 10 day moving average
Now the formula for calculating where the VIX stands relative to its 10 day moving average is simple, and the idea is to buy the market when the VIX has risen above its 10 day average by 5% or more, and sell the market when the VIX has fallen below its 10 day moving average by 5% or more!
The formula is: [(Current VIX reading / 10 day average of VIX) - 1] * 100
When VIX is above the 10 day moving average the result will be positive and vice versa.
For example, on the above chart the highest VIX reading is 30.5, and the 10 day moving average is 25 while the S & P has made a big decline, the VIX trading formula gives a result of 22%, which is super bullish, suggesting that the S & P is making a bottom and will soon rally back up. The minimum formula result must be either 5 or -5 in order to initiate a trade!
A reading of 10 is a buy signal
A reading of -10 is a sell signal
As we said, there are cases where an important level of major support or resistance is more powerful than the $VIX. In such cases the moving average of VIX moves towards actual VIX reading, and the expected market move as suggested by this formula, does not come true. This only happens during extremely powerful rallies and declines, but this is the exception to the rule! Most of the time the VIX indicator is all good traders watch. And by using the above formula you can get an accurate measure of where markets will go, much better than a simple visual observation can.
The rule to apply here, is this: Always be ready to act on signal readings above 5 or below -5, if it’s the rare occasion where the market is in a phase where it will defy this divergence, then so be it. You can go with the trend. But the rule is that the VIX will revert to its average, and in so doing it helps you stay prepared when the market changes direction out of the blue!
This is way better than trying to make sense of the absolute value of VIX, some traders look at just that, and it’s nonsense. Waiting for the VIX to swing between 80 and 20 is a long term process, and still unreliable for short term objectives.