Using the VIX for Options Trading: Predict Market Moves & Trade Smarter

A measure of how much the US stock market is expected to fluctuate over the next 30 days, the Volatility Index (VIX) or the “fear gauge” is released in real-time by the Chicago Board Options Exchange and is calculated by combining the weighted prices of the index’s put and call options and its importance in options trading.

Why is VIX often called the “fear gauge?” This is because it reflects market expectations of volatility, namely investors’ concerns over market volatility and its impact on their investments. Understanding VIX has several great benefits for options traders, including adjusting strategies to maximize profits or hedge risks. We’ll discuss more of these perks as we dive into your VIX guide.

If you want to learn more about VIX, check out our guide, which will explain what it measures, how it relates to market movements, and how traders can use it to refine their options strategies. Discover how other traders’ expectations of future market movement can be used to your advantage as you trade options online.

What Is the VIX?

The Volatility Index (VIX) is the annualized implied volatility of a hypothetical S&P 500 stock option with 30 days to go until its expiration date. The basis for the hypothetical option’s price is the prices of the near-term S&P 500 options traded on the CBOE (Chicago Board Options Exchange). VIX is a tool for investors or traders to estimate how much the S&P 500 Index could possibly fluctuate in the next 30 days.

How Is VIX Calculated?

It’s calculated using options traded on the Chicago Board Options Exchange, where the index takes the total variances of the first and second expirations. They then interpolate the two variances to calculate the 30-day variance, take the square root of the 30-day variances to get volatility as standard deviation, and multiply the volatility by 100.

Many people refer to VIX as the market’s “fear gauge.” It’s a metric that’s used to measure market fear (first and foremost), risk, and stress that comes before investing. This is done by measuring the expected volatility of the US stock market over the next 30 days.

Common Misconceptions

There are several misconceptions that traders have surrounding the Volatility Index (VIX). We’ve outlined them below to set the record straight and put them into the proper perspective for you.

• Low VIX Means Market Stability—A calm market isn’t always the case when the Volatility Index is low. Large market shifts are still possible in these conditions. A low VIX could indicate a period of time where there’s simply a low perceived volatility, but a notable market event could still cause the markets to destabilize.
• Direct Prediction of Volatility—The Volatility Index often will overestimate the actual volatility to the “fear premium,” so the VIX reading doesn’t always clearly indicate the exact percent of volatility expected during the 30 days.
• A Reflection of Current Market Movement—VIX doesn’t reflect the current market movement itself, but instead reflects the market expectations of future volatility since it’s based on the price of options.
• VIX Is a Standalone Trading Signal—You cannot rely on VIX alone without taking other market factors into consideration. It can be a helpful indicator for traders, but it should never be used in isolation. It’s best to pair VIX with other indicators for cross reference.
• Avoid Using General Ranges—This general idea of low VIX being synonymous with low fear and high VIX being synonymous with high fear is okay to use as a rough guideline, but getting a true interpretation of VIX levels means taking other market conditions into account for the correct context and analysis.

The Relationship Between VIX and Market Movements

VIX tends to move in the opposite direction of the market. When the Volatility Index is higher, this is associated with increased fear and risk-taking in the market, while lower VIX tends to see more market stability where investors and traders have more confidence. This next section will have a deeper focus on VIX and how it is related to the S&P 500, as well as examples of historical trends where VIX behaved a certain way in the midst of market conditions that were both stable and rocky.

VIX vs. S&P 500

The correlation between VIX and the S&P 500 is considered a negative correlation where VIX will decrease when the S&P 500 goes up and vice versa.

Bear Markets

When the market is falling, VIX tends to rise, but when the market is rising, VIX tends to fall off. The important thing to note here is that stable market conditions are characterized by very low VIX; however, it doesn’t always indicate that there’s no risk present with investments in that environment.

Bull Markets

In bull markets, VIX tends to stay low, while it’s high in bearish markets. Another concept that we’ll dive into later is that VIX doesn’t indicate that a market crash is incoming (it could, but more often than not, it only signals mean reversion in volatility).

Historical Trends

Two prime examples of VIX spikes during market crises were the 2008 financial crash and the 2020 COVID crash. To give a bit more context, there have only been 114 times since 1990 when VIX spiked above a level of 32.7. These two instances were two of the more recent examples of VIX reaching all-time highs.

• 2008: VIX reached an intraday high of 89.53 on October 24, 2008. Later, on November 21, VIX closed at a record high of 80.74.
• 2020: VIX spiked as much as 48.1 percent to a high of 62.12. Though not as high as the 2008 spike, this VIX spike during the onset of COVID hadn’t been seen since the 2008 financial crash.

VIX behaves much differently during calm bull markets, almost always being under 30.0. The Volatility Index typically remains low or on the decline as investors’ fears are put to rest and the market sees a gentle rise in stock prices. With VIX being low in these conditions, there’s less need for protective options. In fact, this demand is what drives VIX down even lower.

VIX does not always indicate an imminent crash. Even in bull markets, there are times when the VIX will spike during temporary market corrections or periods of uncertainty that arise from other events. VIX might go up for a bit, but it usually doesn’t mean a crash is coming. It simply means that there’s a mean reversion in volatility. When this happens, VIX will drop back down to a lower level.

How to Use VIX to Predict Market Volatility

Traders can use the Volatility Index to gauge market volatility and sentiment as a means of preparing for future periods of market turbulence. It all has to do with correctly interpreting different VIX levels, tracking VIX trends, and gaining additional insights into long-term volatility expectations by using futures contracts in conjunction with the Volatility Index.

Interpreting Different VIX Levels

If you’re looking to make sense of the number that comes with reading VIX levels, we’ve got you covered with all the indicators of high, low, or moderate VIX:

• Low VIX (<15): Stable markets, bullish sentiment, lower option premiums.
• Moderate VIX (15-25): Normal fluctuations, ideal for range-bound trading.
• High VIX (>25-30): Market uncertainty, high option premiums, greater risk.

Tracking VIX Trends

Now, we come to apply VIX for your investment and trading decisions. Where do the VIX levels need to be to enter bullish or bearish positions? The concepts are relatively simple, so much so we outlined them in the following two bullet points:

• Rising VIX → Market expecting higher volatility → Increased risk in long positions.
• Falling VIX → Market stability → Favorable for long-term bullish strategies.

Using VIX Term Structure

Futures contracts on the VIX can provide additional insights into long-term volatility expectations by letting traders see how the market is currently pricing future volatility on different time horizons. Traders can find out if the market is predicting increased volatility or decreased volatility beyond the current timeframe. It could be in the coming months or even years.

Important Considerations

• Term Structure: Comparing future contracts of VIX at different expiration dates, traders can view the “term structure” of volatility. This means determining if the market sees near-term volatility to be higher or lower than the long-term volatility.
• Hedging for the Future: VIX futures are a great tool for traders to hedge their investments for the future against possible market downturns. Purchasing VIX futures can help them insulate their capital when they expect increased volatility.
• Assessing Risk: Once traders have a good understanding of the market’s long-term expectations for volatility, they can better assess the risks that come with their positions and make better decisions about their capital allocation.
• Market Sentiment: The market could be signaling to traders that they’re expecting an uptick in volatility shortly when there’s a steep upward slope in the VIX futures curve. Flatter curves are another clue. They signal or indicate that stable market conditions are expected.

Adjusting Your Options Trades Based on VIX Readings

While traders are keeping an eye on VIX readings, they must be able to pivot to different strategies based on how much the VIX reading will change with time. We’ll discuss the best moves for high and low-volatility environments as well as the best ways to adjust your positions adeptly during volatility spikes.

Trading Strategies for a Low VIX Environment

Check out the best moves that traders can make when they find themselves in the midst of an environment characterized by a low Volatility Index. These times of lower VIX suggest market calm, so traders will generally be buying call options and making other bullish moves.

• Buying Long Calls & Spreads: If you catch wind that options are trading with low implied volatility levels, it’s good to consider options like buying long calls, long straddles, or debit spreads. They are going to come with cheaper premiums making these options far more attractive to pursue and less desirable to sell. Lower volatility means cheaper options in the long run.
• Selling Credit spreads: This strategy can be super effective when lower expected volatility is present. In these environments, traders can collect premiums and profit from time decay, which ultimately reduces risks for premium sellers. Another key appeal is the fact that selling credit spreads comes with defined risks when the maximum potential is limited to the difference between the strike prices.
• Avoiding Naked Short Options: Naked short options like naked calls or puts are not great for these conditions due to their unlimited risk potential. The potential losses are high if the underlying asset moves against the short position. Low volatility can lead to sudden spikes, so it’s best to avoid these moves altogether when VIX is low.

Trading Strategies for a High VIX Environment

An environment that’s characterized by higher VIX is one where traders will be dealing with market downturns or bracing for increased volatility. In these times of increased fear and uncertainty, traders will generally be selling more than buying.

• Selling Options (Puts and Calls): This is a preferable move for options traders as it can capitalize on the expectation that volatility will revert to its means when options premiums are typically high when VIX is high. These conditions lead to more expensive premiums which ultimately lead to good conditions for premium sellers.
• Iron Condors and Strangles: Between the two, the strangle is the better move as it offers higher potential returns and risks due to its undefined nature. However, the iron condor might be the more suitable strategy if you prefer a declined risk strategy with low potential returns. In both cases, wider price movements allow for profitable volatility-based trades.
• Avoiding Buying Options Outright: High IV inflates options prices. It’s best to not purchase a simple call or put an option on the stock directly. It’s a possibly risky strategy due to the potential for losses incurred through increased volatility or time decay. This could result in the option’s value decreasing further if the underlying stock price remains stable.

Adjusting Positions During Volatility Spikes

It’s recommended that options traders adjust positions during volatility spikes because those are prime opportunities to increase your profit potential, even if the risk element goes up too. The key to success here is to stay current with range potential for a couple of timeframes during a crisis when VIX spends some considerable time above 20.

• Hedging With VIX-Based Instruments: VIX futures, ETFs, or VIX options can all be used by traders to hedge their positions. VIX hedges are important to enter early before an expected market crash. Use currency-based ETFs to take a counterbalancing position in your portfolio to protect yourself from fluctuations in the exchange rate when investing in foreign assets. VIX futures can help you make a profit from a large event such as a market crash.
• Using Delta-Neutral Strategies: Straddles and strangles are two excellent delta-neutral strategies that traders can use to benefit from volatility without market bias. If you can pivot your strategy to include either of these techniques when you aren’t sure of which direction the market is going, you can still make money by simply correctly predicting that the market will be volatile.
• Rolling Options Positions: This is a common strategy to take advantage of implied volatility shifts. In options rolling, the trader is closing one position while simultaneously opening a new one. The new positions usually come with an expiration date that’s further out in time and sometimes it features a different strike price. While this move isn’t a guaranteed way to lock in a profit, it’s a great method for adjusting your position to take advantage of market volatility.

Common Mistakes Traders Make When Using VIX

If you can avoid making these mistakes, you’ll have a much better experience trading based on the Volatility Index. Traders who can use VIX as a risk management tool,[ understand market context, implement strict risk management, and focus on hedging strategies will do a lot better with avoiding these mistakes than those who cannot put these important steps into practice.

• Assuming High VIX Always Means a Crash: High VIX based on the CBOE Volatility Index does not always point to a market crash occurring. However, this is an indication of increased investor fear and anticipated volatility in the market. More often than not, it signals an economic downturn, but it can sometimes be a crash. High VIX can remain elevated without a sharp drop.
• Misinterpreting Low VIX as Risk-Free: Some investors make the mistake of assuming that low VIX means that the trade comes with no risks. A low VOX actually suggests investors are expecting lower volatility and relative market stability. However, market risk can still be a factor, even in these conditions. Complacency often precedes market corrections, so be watchful even if VIX is looking low.
• Misunderstanding the Reason Behind Using VIX: VIX serves as a gauge of market volatility instead of using it as a predictive tool of market direction. Using VIX to time market bottoms can lead to traders incurring some severe losses due to a simple misunderstanding of how it’s supposed to work.
• Not Adjusting Position Size: Not adjusting your position size based on the current levels of VIX can result in traders risking too much capital and leaving them open to more risk than is necessary.
• Chasing Volatility: It’s a mistake to jump into a position simply for the fact that VIX is high. Poor decision-making can occur when traders don’t consider the underlying market conditions.
• Over-Leveraging: Losses can be amplified when investors use excessive leverage in trading VIX-based instruments in volatile market scenarios.

Use VIX to Gauge the Market

The Volatility Index is a measurement of how much the US stock market is expected to fluctuate over the next 30 days. Some call it the “fear gauge,” but there’s nothing to fear when it comes to leveraging it to your advantage in trading.

We’re going over the definition of VIX again to remind you of what it is and what it’s to be used for. Remember that the purpose of using VIX in options trading is to gain insights into the expected volatility of the market and not to use it as a predictive tool for market direction. Misunderstanding the purpose of this tool can land traders in a lot of trouble with their money.

Use VIX trends to gauge market sentiment. Then you should adjust your options strategies accordingly, like buying in low-VIX periods or selling in high-VIX periods. Be sure to combine VIX with other indicators for a comprehensive trading strategy. Track VIX regularly and backtest strategies before implementing them in real trades.