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What You Know About the VIX Is Wrong – Here’s How to Trade It

2 | By Shah Gilani

Most people who know anything about the stock market probably know a few things about the VIX (^VIX).

Investors know “the VIX” is a volatility index and that is often called “the fear index.”  They know that, when the VIX is rising especially quickly, there’s a chance there’s going to be trouble ahead and markets might be in danger of selling off… Or possibly crashing.

But that’s like looking at the tip of an iceberg and saying that’s all you need to know about what’s underneath the surface. That would be a huge mistake. Just ask the captain of the Titanic.

I’m sharing, without the heavy math, a clear look-through to the depths of the VIX as opposed to what you think you see on the surface.

Here’s what you need to know about what really floats the VIX, and how to trade it for huge gains…

The Whole Truth About the VIX

First of all, the VIX is a measure of the volatility of the S&P 500 (^SPX).

However, the VIX is not the only volatility index (or, just “vix”). There are volatility measures or indexes based on other stock market benchmarks, like for the Dow Jones Industrials Average (^VXD) and the NASDAQ 100 (^VXN).

There’s a vix for the 10-year U.S. Treasury (^TYVIX), Crude Oil (^OVX), and Gold (^GVX). There’s even a vix of individual stocks like Amazon (^VXAZN) and Apple (^VXAPL). My programming team has developed proprietary vix measures of almost every stock, as well as other instruments. Goldman Sachs has all their vix measures, so does every quant shop.

There’s even a VIX Volatility Index (^VVIX).

According to the CBOE:

“Every asset class deserves its own volatility index, including volatility itself. The VVIX Index is an indicator of the expected volatility of the 30-day forward price of the VIX. This volatility drives nearby VIX option prices. CBOE also calculates a term structure of VVIX for different VIX expirations. The VVIX or any point on its term structure is calculated from a portfolio of VIX options (VVIX portfolio) using the same algorithm used to calculate the VIX. Approximate fair values of VIX futures prices and their standard deviations are derived from the VVIX term structure. Selling a VVIX portfolio on a consistent basis can capture a volatility risk premium.”

I know I said I wouldn’t get into heavy math; just pat yourself on the back that you know there’s a vix of the VIX.

What most investors don’t know, however, is that the VIX (or any vix for that matter) isn’t exactly what it’s supposed to be. It’s close, but it just isn’t.

And I should know – because I was among a select group of traders who helped develop the VIX.

The VIX is calculated from a series of puts and calls on the SPX expiring within 16-44 days, and the number derived from that calculation is the market’s expectation that the S&P 500 (the SPX) could go up or down.

For example, say it’s 10.65 (about where it closed yesterday). That would indicate the markets expect the SPX to go up or down 10.65% in the next 12 months. If the number derived from the calculation were 40 (which is very high), that would indicate the markets expect the SPX to go up or down 40% in the next 12 months.

When investors see the VIX rising to 40, there’s panic that the market’s pending move over the next 12 months won’t be up 40%, but down 40%. Hence the nickname: the fear index.

But what’s wrong with that understanding is that’s not exactly what’s going to happen.

This is what I mean when I say the VIX isn’t exactly what it’s supposed to be. You’d see the VIX at 40 and think, “Trouble ahead, big trouble!” However, what people are using it to predict (or what it’s “supposed to be”) has already happened.

The VIX can only get to 40 if there’s a lot of buying of puts, and probably a lot of selling of calls. But mathematically there’s more weight (skew) on the puts component of the VIX than the calls. Investors are buying puts and paying up for them to hedge portfolios and to profit from a downdraft or big selloff.

Newsflash! If the VIX is at 40, it’s already happened; the markets already dropped enough to warrant bidding up premiums (prices) for puts as fear and selling set in.

What I’m saying is that by the time investors see the VIX at 40, and interpret that to mean that in the coming 12-months the SPX could move up or down 40%, it’s already mostly happened.

That should be a revelation. And it should give you a distinct leg up when trading the VIX.

How to Trade the VIX Better Than Anyone Else

Here’s how it works.

When measuring the volatility of each of the puts and calls used to yield the VIX, the mathematical volatility number that’s extracted from each of the options isn’t historical volatility, it’s “implied” volatility.

Implied volatility is the actual mathematical measure of volatility in the premium price of an option based on the actual price of that option at the exact time you’re measuring it.

It’s called implied volatility because the price (premium) of the option is precisely what it is. Investors paid that price based on the volatility they think should be applied to the price of the option.

Volatility’s implied in the price.

I’ll say it again. In calculating the VIX, each of the implied volatility numbers for each of the puts and calls on the SPX are extracted and used to calculate the VIX. In other words, investors’ volatility expectations are already built into the options and into the VIX.

The likelihood of the SPX moving up or down 40% after the VIX gets to 40 is actually unlikely over the next 12 months, because a big market move has already happened to move the VIX to 40.

This is where a lot of investors lose a lot of money because of the VIX.

They play the market into the future, based on their belief that the 40 reading is saying there’s a 66.7% chance the market will move 40%. They play the VIX as if it’s got to go higher because of the fear of a 40% drop will cause more put buying.

Too late.

The way to play the VIX, if you’re trading the VIX in any of its many instrument forms, is to watch for the volatility of the VIX picking up. You can look for that by watching the VVIX and the VIX to see if it’s rising at the same time the market’s falling. I prefer straight up puts and calls.

If you want a shot at making big money on the VIX, you have to buy in when volatility is slowly rising and you anticipate it jumping higher because you’re also watching the market start to back-up. For that I would use calls about three months out.

If you catch the VIX right and it jumps to something like 40, you should sell right away and take your profit. You’d be sitting on huge gains if you bought, say, 15 or 20 strike calls!

The likelihood of the market going down 40% in 12 months after the VIX gets to 40 is probably behind you. If it does go down 40% from there, we’re all in big trouble.

The way I’d play the VIX if it got to 40 would be to not only sell my calls, I’d buy puts to profit when it falls back to earth.

That’s called “mean reversion” trading, and you can apply that to the VIX or the vix of any instrument.

Now you can play it right.

Sincerely,

Shah

2 Responses to What You Know About the VIX Is Wrong – Here’s How to Trade It

  1. Lucien Vandenplas says:

    Hi Mr. Gilani,

    If I understand you correctly, the VIX is a look in the past, rather than in the future?
    Thank you for enlightening us.

  2. Pat says:

    Thank you for this amazing article. Your explanation of the workings of the VIX has changed my understanding of trading the stock market. Many thanks.

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