What Is Volatility and How to Trade It
Market Analysis - | 28 May 2019
In most instances, traders are making decisions on whether a market is rising or falling when they’re looking to place a profitable trade. A steady move in one direction is fertile ground for even the most straightforward of trading strategies – it ensures margin calls or stops aren’t triggered and profits keep on being accrued. Of course, such utopian trading conditions are impossible to predict and can typically only be realised with the benefit of hindsight. A surprise economic announcement, deterioration in the geopolitical narrative or even a technical level being breached can be sufficient to throw any asset price off course.
Volatility on single stocks
Volatility is a measure of how much an asset’s price is moving, either when compared against an historic average or alternatively when viewed in relation to another asset. Look at the technical analyst notes for a blue-chip stock and you’ll typically see a reference to something called beta. A beta of 1 means that the stock has, on average, historically correlated exactly with the entire market. A beta of 1.5 would mean that again historically the share price outperforms the market by 50%, so a 10% rise or fall in the market would on average have delivered a 15% rise or fall in the asset and so on.
Index volatility – a fear index
Understanding volatility can, therefore, be useful when it comes to building a balanced portfolio, but the intent of this article is to discuss the volatility index known as the VIX. Often commonly referred to as the ‘fear gauge’ or ‘fear index’, the VIX tracks the expected volatility of S&P500 Index futures. If the index is moving gradually in one direction or the other, then the VIX will have a low number. As volatility increases however and the market starts jumping around, the VIX will rise.
The VIX in history
The chart below illustrates the performance of the VIX over the last 20 years. Spikes are clearly visible around key events which have served to move US equities.
The biggest spike here is the credit crisis, just over a decade ago. The VIX hit almost 90 as panic gripped stock markets across the globe.
More recently, in February 2018 again the VIX spiked as the stock market tanked. Concern that inflation was about to take off in the US, which in turn would drive a run of rate hikes saw shares slump. The VIX went from 12 to 50, before reverting in the subsequent weeks.
Notable losses for US stocks in recent weeks as trade tensions grew have also served up a bounce for the VIX, which went from 12.8 at the start of May to almost doubling in value by May 9th.
Chart source: Bloomberg
AxiTrader now offers its clients the ability to trade the VIX, with market hours being from 5pm on a Sunday to 4pm on a Friday, based on Chicago time. As the chart illustrates, there’s a typical baseline reading, with the lowest level recorded over the last twenty years having been 8.56 in 2017. That reflects what could be seen as frictional volatility - it would certainly be very unusual for the market to be seen as not moving at all.
One benefit of trading the VIX is that you’re not trying to call the direction of the market, just that the underlying volatility will increase or decrease. Whether it’s an unexpected tweet from Donald Trump or meaningful developments in terms of global trade talk, there’s no shortage of factors which can drive increased activity in the underlying market - and have the potential to hike volatility as a result.
Three possible VIX trading strategies
As the chart above shows, the VIX has in the last 20 years never gone below 8.56 owing to this ‘frictional’ volatility which persists. In theory it could go to zero, but if the VIX is low and you believe that more volatile market conditions lie ahead, then taking a long position on the index has the potential to yield results.
Conversely, whilst there’s no maximum level of volatility which can be achieved on the VIX, the highest level seen in the last 20 years by the index is just under 90. The VIX falling from recent highs backed by a positive geopolitical and economic outlook could therefore make for a good short trade.
A third option is to simply use the VIX as a handy gauge if you’re trading other instruments which have a degree of correlation to the S&P500 - which after all is the index the VIX is trying to highlight the future volatility of. So, assuming you have a position on the US500, which itself follows the S&P500 futures, complete with stops and limits. If you see the VIX move higher, it may be prudent to adjust your trading strategy. This could include moving stops and limits further out and accordingly reducing the scale of any investment. Your maximum profit or loss would remain unchanged but this should prevent limits being triggered too quickly. Conversely, if the VIX is falling, you may want to consider making opposing changes to a trading strategy.
The information is not to be construed as a recommendation; or an offer to buy or sell; or the solicitation of an offer to buy or sell any security, financial product, or instrument; or to participate in any trading strategy. Readers should seek their own advice. Reproduction or redistribution of this information is not permitted.
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