VIX trading strategies seek to profit from signals generated by or related to the VIX Index, the standard measure of US equity market volatility. This article will explain what the VIX Index is and what instruments a retail trader can trade to profit from changes in equity market volatility, and also highlight three VIX-related signals worth monitoring.
If you are looking for advanced research on how to trade S&P 500 index products based on VIX signals, we recommend that you read our academic study, Backtesting Signals Derived from VIX Backwardation, Market Breadth and Market Spreads.
VIX Index Explained
The VIX is also known as the "fear index". It measures expectations for stock market volatility over the next 30 days by using options data in combination with other factors such as volume data and open interest index data in order to compute a value. A higher VIX number indicates traders believe volatility will be high.
Instruments you can use to trade VIX-based signals
There are multiple instruments a retail trader can use to implement a trading strategy based on VIX-related signals. Here are a few:
SPDR S&P 500 ETF Trust
SPY is an ETF that tracks the S&P 500 Index, which consists of 50% of the market capitalization of all US stocks traded on a national exchange and gives investors exposure to U.S. large cap equity securities. By trading SPY based on VIX-related signals, a trader takes bullish or bearish positions in US equities depending on changes in the value of a volatility indicator.
VXX and UVXY ETNs
VXX and UVXY are ETNs that offers exposure to VIX futures. By trading either, a trader takes bullish or bearish positions in volatility that are indirectly related to the value of the VIX. However, both of these instruments have a distinct characterization. The value of ETNs are based on the value of VIX futures, which tend to lose money over time due to contango—a situation in which VIX futures tend to be priced higher than VIX spot.
SVXY is also an ETN, but its value rises inversely with the value of VIX short term futures. More often than not, long exposure to products like SVXY tend to make money, however, short-VIX products are inherently fragile, making them vulnerable to blow-up risk when the VIX index spikes unexpectedly. For example, a shock of volatility in February 2018 sent the erstwhile ETN XIV crashing.
Important Volatility Signals
Here are three volatility metrics traders may want to consider using to trigger VIX-rekated trades.
VIX Futures Term Structure, specifically the M1-M2 (VX1,VX2) Spread
The term structure refers to the relationship between shorter-dated and longer-dated futures contracts. The M-spread represents the volatility differential between front month VIX futures contracts, specifically VX monthly expiration months (VXM). M-spreads provide valuable information since they represent short term expectations for movement and are closely related with market sentiment . The spread increases in value when traders are confident that VIX futures prices will increase over time, such as during periods of low economic activity when there's less uncertainty about price volatility.
Implied-Realized Volatility Spread
Implied volatility represents the current market price for volatility, or the fair value of volatility based on the market's expectation for movement over a defined period of time. Realized volatility, on the other hand, is the actual movement that occurs in a given underlying over a defined past period. The difference between both of these is the realized volatility spread.
VIX-30 Day Realized Volatility Spread
This is calculated by subtracting the 30-day implied volatility, as calculated by VIX, from the 21-day historical realized volatility. A high number implies expected high volatility, while a lower one suggests expectations for decreased movement over time. This metric can be used as an indication whether options are overpriced or under-priced compared relative to market expectations.
Backtesting VIX-based trading strategies
Trading VIX-based strategies has become increasingly popular over the last few years, and for good reason—they're a great way to speculate in relatively short time periods.
However, it's always important to backtest your strategy before you trade it, in order to ensure that your approach really provides an edge. Traders can find out how any of these VIX-based metrics influence the forward return of assets like SPY and VXX simply by running a backtest simulation on Tradewell's platform.