The VIX index is a well-known and widely-followed index that helps traders measure the levels of fear and greed in the market.
Although you can’t directly trade the VIX index, there is a number of VIX derivatives that can be traded whenever the market is open, including futures, options, CFDs, and ETFs that track the VIX index.
Here, we’ve covered the most popular VIX trading strategies with a clear description of the entry and exit rules.
VIX Index Explained
The VIX index, also known as the “fear index” is reported by the Chicago Board Options Exchange and provides investors and traders valuable insight into current greed and fear levels in the market.
The VIX index is based on future expectations for volatility in the S&P 500, i.e. it calculates the implied volatility of S&P 500 options for the following 30 trading days.
Options are derivative contracts that track the price of an underlying asset. Since the price of an option contract depends on the probability of the underlying asset to reach a pre-specified level (the option’s strike price), options can be used to measure the implied volatility of the underlying asset and general market sentiment towards the asset. That’s why options on the S&P 500 can be used to measure the “fear” level of the broader market.
Market participants often use the VIX index to measure market risk and sentiment before making important trading decisions. The VIX index was introduced in 1993, and the CBOE added VIX futures in 2004.
Trading VIX Derivatives
Since traders can’t directly trade the VIX index, there’s a number of VIX derivatives that are designed to track the index as closely as possible. Besides VIX futures, traders can also trade on VIX CFDs and VIX ETPs (Exchange Traded Products). Here’s a list of the most popular VIX derivatives that can be traded on the market:
- S&P 500 VIX Short-Term Futures ETN (VXX)
- VIX Short-Term Futures ETF (VIXY)
- ProShares’ Short VIX Short-Term Futures ETF (SVXY)
- S&P 500 VIX Mid-Term Futures ETN (VXZ)
It’s important to note that real-time prices of VIX ETFs can sometimes sharply differ from the underlying indicator, often as the result of contango (timing variation between a futures contract and the current spot price). That’s why short-term VIX trading strategies with aggressive entries and exits (such as the VIX reversal strategy) often provide better results than longer-term ones.
Most of the popular VIX trading strategies are based on reversals and mean-reversion. Since the VIX is mostly trading sideways, using trend-following strategies to trade the index would result in many fake signals and potentially large losses.
Top VIX Trading Strategies
Strategy #1: Trading VIX Volatility
One of the most popular strategies to trade the VIX index is to trade its volatility with the use of some basic technical indicators. In this strategy, we’re using Bollinger Bands and moving averages to determine entry and exit points for our trades.
Bollinger Bands is a volatility indicator that plots a channel two standard deviations away from a moving average. In this example, we’re using the standard Bollinger Bands settings with a 20-period MA.
The following chart shows the VIX short-term futures ETF with Bollinger Bands applied to it. The green arrows indicate possible buy signals, and the red arrows possible sell signals.
The rules of the strategy are as follows:
- Wait for the VIXY to reach the upper or lower channel of the Bollinger Bands. The upper channel sends a sell signal, and the lower channel sends a buy signal.
- To confirm our entry, zoom into a lower timeframe, and wait for the moving average to confirm the trade. The MA should move downwards on the lower timeframe when the VIX reaches the upper channel on the higher timeframe to confirm a sell trade, and vice-versa.
- Our profit target is set at the centre of the Bollinger Bands (the 20-period MA).
- Stop-loss orders can be placed just above (below) the Bollinger Band.
Strategy #2: Trading VIX Reversals
Another popular VIX trading strategy is the Reversal strategy, which takes advantage of the mean-reversion characteristics of the index. The strategy uses a similar approach to the volatility strategy, with the difference that all trading decisions are based on moving averages, and that there’s always going to be an open trade in the market.
For this strategy, we’ll use two moving averages. The faster MA has a 5-period setting, and the slower MA a 15-period setting. The following chart shows how the VIX index chart looks like with the MAs applied to it. Again, the green arrows signal possible buy setups, while the red arrows signal possible sell setups.
Here are the rules of the Reversal strategy:
- Wait for the faster 5-period MA to cross above the slower 15-period MA to open a buy trade.
- When the 5-period MA crosses below the 15-period MA, it’s time to close the buy trade and immediately open a sell trade.
- When the 5-period MA crosses above the 15-period MA again, it’s time to close the sell trade and immediately open a buy trade.
- Stop-losses are placed just above the recent swing high for sell signals, and just below the recent swing low for buy signals.
As you can see, there are no profit targets with this strategy and there’s always an open trade in the market. Once you close a long position, you open a short position, and vice-versa.
Since there’s always an open trade, we have to protect our account when liquidity is low and when we don’t want to trade. That’s why the Reversal strategy also uses a time filter, which closes all open trades just before the market closes. Close all your open trades around 10-minutes before the closing bells ring.
Strategy #3: Trading VIX Divergences
The third VIX trading strategy involves trading divergences between the index and the underlying stock index. Since the VIX index derives its value from the implied volatility of S&P 500 options, it’s no wonder that both instruments are closely correlated. A rising VIX usually means a falling S&P 500, and vice-versa.
The VIX Divergence strategy aims to take advantage of the relationships between the VIX index and stock indices.
The rules of the VIX strategy are explained below:
- A falling VIX index combined with a falling S&P 500 is a bullish divergence. This increases the odds of an upside reversal.
- A rising VIX index combined with a rising S&P 500 is a bearish divergence, signalling a possible downside reversal.
- A falling VIX index combined with a rising S&P 500 is a bullish convergence, signalling further strength in the S&P 500 and/or weakness in the VIX.
- A rising VIX index combined with falling S&P 500 is a bearish convergence, signalling further weakness in the S&P 500 and/or strength in the VIX.
To trade the divergence strategy, simply add two charts to your trading platform (VIX and S&P 500) and closely follow the price action of both instruments.
Trading the VIX index is not a simple task. The VIX index is not a stock, which means there’re no earning reports or other fundamental data to support your analysis. Since the index doesn’t follow supply and demand in the market, technical levels are also pretty much worthless.
That’s why all of the strategies aim to take advantage of the mean-reverting nature of the index and its relationship with stock indices. Bear in mind that the VIX can be very volatile at times, so try to use stop-losses in all of your trades.