VIX Timing Strategy

By Samantha Baltodano

TL;DR:

The VIX Timing strategy is a forecasting tool that uses the Chicago Board Options Exchange Market Volatility Index (VIX) to indicate buying or selling opportunities for broad-based indexes. The VIX is a measure of the level of implied volatility of a wide range of options based on the S&P 500 and is sometimes referred to as "the fear index" because it reflects investors' best predictions of near-term market volatility. Trade signals for the VIX Timing strategy are based on the relationship between the VIX and its simple moving average. A buy order is added after the VIX has consistently been below its moving average during a trend period, and a sell order is added after the VIX has consistently been above its moving average.

What Is VIX Timing Strategy?

The VIX Timing strategy is a forecasting tool that uses Chicago Board Options Exchange Market Volatility Index (VIX) in order to indicate buying or selling opportunities for broad-based indexes like the S&P 500 and the Dow Jones Industrial Average. 

It is a measure of the level of implied volatility, not historical or statistical volatility, of a wide range of options, based on the S&P 500. 

The VIX is sometimes called "the fear index" because it reflects investors' best predictions of near-term market volatility, or risk. It represents implied volatility in the stock market for the next 30 days.

In general, VIX starts to rise during times of financial stress and lessens as investors become complacent. It is the market's best prediction of near-term market volatility.

What Does Implied Volatility Mean?

Well, I’m happy you asked!

Implied volatility is the expected volatility of the underlying, in this case, a wide range of options on the S&P 500 Index. 

It represents the level of price volatility implied by the options markets, not the actual or historical volatility of the index itself. 

If implied volatility is high, the premium on options will be high and vice versa. Generally speaking, rising option premiums, if we assume all other variables remain constant, reflect a rising expectation of future volatility of the underlying stock index, which represents higher implied volatility levels.

Vix and Stock Market Behavior

While there are other factors at work, in most cases, a high VIX reflects increased investor fear and a low VIX suggests complacency. 

Historically, this pattern in the relationship between the VIX and the behavior of the stock market has repeated itself in bull and bear cycles. 

During periods of market turmoil, the VIX spikes higher, largely reflecting the panic demand for OEX puts as a hedge against further declines in stock portfolios. 

During bullish periods, there is less fear and, therefore, less need for portfolio managers to purchase puts.

By measuring investor fear levels tick by tick, and day by day, the VIX, like many emotional gauges such as put/call ratio and sentiment surveys, can be used as a contrary opinion tool in attempting to pinpoint market tops and bottoms on a medium-term basis.

There are two ways to use the VIX in this manner: 

The first is to look at the actual level of the VIX to determine its stock-market implications. Another approach involves looking at ratios comparing the current level to the long-term moving average of the VIX. 

This second method, known as detrending, helps to remove long-term trends in the VIX, providing a more stable reading in the form of an oscillator.

Trade Signals

Now, what you’ve probably been waiting for… trade signals using VIX.

According to the rules described by Trent Gardner in his article "Using VIX To Forecast The S&P 500", trade signals are given based the following conditions:

• Buy order is added after the VIX has constantly been below its SMA during trend period,
• Sell order is added after the VIX has constantly been above its SMA during trend period.

Summary

• The VIX Timing strategy uses the VIX to indicate buying or selling opportunities for broad-based indexes
• The VIX is a measure of the level of implied volatility of options based on the S&P 500 and is sometimes referred to as "the fear index"
• Trade signals for the VIX Timing strategy are based on the relationship between the VIX and its simple moving average
• A buy order is added after the VIX has consistently been below its moving average during a trend period, and a sell order is added after the VIX has consistently been above its moving average

VIX Timing is just one of many strategies that Archaide automates. For a full list of strategies and studies available click here.

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