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Beginner's guide to understanding the VIX

VIX or Volatility Index is one of the most widely used terms in the financial markets. You will hear a lot about this when the equity markets are bearish. Sometimes, referred to as the fear index, the VIX or the volatility index is a very useful tool.

Whether you are trading forex or commodities, the volatility index has an impact on the markets. This is because the volatility index is a measure of the market sentiment. Therefore, it is wise that traders keep an eye on the VIX every now and then to gauge the mood of the markets.

As you might already know, when the market sentiment is bullish, riskier assets including some currency pairs in forex tend to outperform the safe haven currencies. So what is the VIX and what does it do?


What is the VIX index and how does it work?

The volatility index is a real time market index that measures volatility in the equity markets, looking ahead for 30-days. The VIX index is derived from the S&P500 index options. Options are derivative contracts, widely used as a hedging tool.

The index is managed by the CBOE (Chicago Board of Options Exchange) and it is used by hedge fund managers, investors and analysts. Based on the inputs from the S&P500 options with a 30-day expiry, the ratio of calls and puts are then derived into the VIX index.

The VIX was first introduced in 1993 by the CBOE and is now a widely recognized benchmark for stock market volatility. The data is calculated in real time and represents the 30-day future volatility for the S&P500 index.

The options are based on a 30-day contract which expires on the third Friday of every month.

The Volatility Index has a baseline of 0. When the number of calls (bullish bets) are more than the puts (bearish bets), the VIX falls. Likewise, when the puts outnumber the calls, the VIX starts to rise. This coincides with the equity markets often crashing or making a sharp correction.

In the chart below, you can see how the red flags on the VIX (bottom part of the chart) signals the sharp correction in the S&P500 futures contract.

01 VIX

Example of the VIX and the S&P500 futures index

When the VIX moves above the 30 level investors tend to get fearful of the market. This can happen due to a number of reasons. But the primary reason is that investors begin to make more bearish bets in the options market in order to hedge their long positions in the equity markets. This means that investors sense that there could be a stock market correction.

VIX is not just a measurement of the market index. Investors are also able to trade the VIX directly. This is done via options on the VIX, which is a bet on whether the VIX will rise, indicating a market correction or if it falls, suggesting that investor sentiment is bullish.


How can traders use the VIX in the forex markets?

We already know that the VIX or the fear index is a gauge of the investor sentiment in the market. Therefore, we can already deduce from the fact that when the VIX is rising, safe haven assets tend to outperform the riskier assets.

In other words, when the VIX is rising, meaning that investors are fearful of the markets, safe haven assets such as the Japanese yen, gold and US Treasuries tend to outperform, the riskier assets such as equities, commodity currencies such as the AUD, NZD, CAD, NOK and so on.

02 AUDUSD VIX

AUDUSD compared to the VIX

The chart above shows the AUDUSD currency pair alongside the VIX. You can once again see how a rising VIX tends to coincide with a bottom in the Australian dollar. However, we should caution that the moves are not 1:1. In other words, you will experience some lag or lead. This means that at times the asset you are analyzing might make a bottom much before the VIX or vice versa.

The VIX should not be used as buy or sell indicator. Rather, its purpose is to alert you on when it is a good time to go long or short on the risk or safe haven currencies.

As a thumb rule, simply look to the VIX level of 25 and higher. When you see the index rising above this level, you should adjust your bullish or bearish bias accordingly. While using the VIX will not directly increase your bottom line profits, it will help you to time the markets and know when there is a risk on or a risk off sentiment.

Read 53 times Last modified on Wednesday, 15 July 2020 13:22

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