Trading Markets: Understand the VIX to Understand Price Action
|Headlines like these need to be put into perspective:
- “US registers its biggest one-day rise since 1933”.
- “Global markets fall 12%, their biggest one-day loss since the 1987 flash”.
- “Markets slashed, Markets surge”.
- "$187 billion dollars wiped from markets” etc.
These kinds of headlines make us look straight to one indicator – volatility. Why? Because understanding ‘vol’ as traders in these times is vital to your trading and risk management.
First off, we need to understand how the VIX index can tell us the daily implied move.
Without diving too far into statistics and modelling, the daily implied move can be worked out by the square root of time. i.e. the square root of 252 days (the amount of trading days in a year) which is 15.8.
From there, divide the VIX index by 15.8 –so when the VIX maxed out at 82 last week, the implied move in the S&P 500 was +/- 5.2%.
It’s important to acknowledge that volatility does not recognise direction, it can’t tell you that. But clearly rampant vol. is due to mass increases in put buying, which is caused by high levels of market selling. So, for most of the time, the market is likely to fall in high bouts of vol.
This information can give you a base to understand your trading risk and price ranges.
Again, using the idea above, the implied daily range, with a VIX of 82, is 10.4% (+5.2% or -5.2%), which we have seen in intraday trading. Think back to Friday the 13th, the ASX initially fell over 4.7% then rallied back and closed up over 4.4%.
In understanding vol., you understand your trade risk. And in understanding your risk, you can make more informed trading decisions.
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