Trading in the stock market is heavily influenced by emotions, and feelings like fear and greed often lead to poor decision-making and unsatisfactory results. Without a clear understanding of market sentiment, traders struggle to make informed decisions. Many lack reliable indicators to gauge these emotional shifts in the market.
The VIX Index, commonly known as the “fear index,” is one of the most effective tools for assessing market volatility and sentiment. It reflects the anticipated volatility of S&P 500 options, providing insights into investors’ expectations of future market movements. Calculated in real-time, the VIX helps traders decide when to enter or exit trades based on current market conditions.
In this article, we’ll explore how to use the VIX effectively within trading strategies. We’ll cover four specific VIX trading strategies, detailing each with rules and results, to show how they build on one another. By the end, you’ll gain a clearer understanding of how the VIX can enhance your trading decisions and, ideally, improve your returns.
What is the VIX Index?
The VIX Index tracks the implied volatility of S&P 500 options, providing insights into investor expectations about future market movements. A high VIX level suggests heightened fear among investors, whereas a low level indicates a sense of complacency. Interestingly, this relationship is inverse: as the VIX rises, the stock market tends to decline, and when the VIX falls, the market often rises.
VIX Readings Key Insights
- High VIX: Suggests fear and possible market downturns.
- Low VIX: That suggests complacency and probably a correction.
These insights can help traders time entry and exit in the market: that is, control risk and discover more opportunities.
Testing VIX Trading Strategies on Backtesting
Strategy 1: VIX and Moving Averages
Trading Rules:
- Buy: Whenever VIX is above its 20-day moving average.
- Exit: When S and P 500’s close is more elevated than the previous day’s high.
- Average Daily Return (VIX > 20-day MA): 0.05%
- Average Daily Return (VIX < 20-day MA): 0.03%
- Equity Curve: The equity curve is steadily increasing when the VIX is high.
The outcome is that, by averages, returns are higher during higher volatility periods, meaning the strategy works.
Strategy 2: VIX with Bollinger Bands
Trading Rules:
- Buy: When the VIX breaks out above its upper Bollinger Band, 10-day (2 standard deviations).
- Exit: When the S&P 500’s close is higher than its previous day’s high.
Performance:
- Average Return per Trade: 0.45%
- Annualised Returns: 4.6%
- Max Loss: 22% (compared to 55% for S&P 500).
This is much lower than the return of a buy-and-hold but cuts the loss significantly and provides an excellent return when volatility is high.
Strategy 3: Breakout Strategy
Rules :
- Entry: When the VIX hits a new 20-day high, and the 5-day RSI is greater than 65.
- Exit: At the close of day when the S&P 500 is greater than its prior day’s high.
Performance:
Average Return per Trade: 0.55%
Annual Returns: 4.8%
Max Drawdown: 22%.
This strategy extends from the previous ones in incorporating an RSI filter, which means that the entry is much more accurate without drawing too high in drawdowns.
Strategy 4: Overnight Trading Strategy
Trading Rules:
- Buy: Day end.
- Sell: Next day end.
Outcome:
- Average Return Per Trade: 0.28%
- Total Trades Since 2000: 577
- Risk-Adjusted Return: 69.
This overnight trading strategy may not catch up with buy and hold strategies but reduces the period of exposure to markets and captures short run moving market fluctuations.
Conclusion
These strategies offer valuable insights for traders seeking to understand market sentiment and volatility. Each of the four approaches demonstrates a way to leverage the VIX to potentially generate profits. While individual results vary, the combined findings suggest that trading during periods of high volatility often leads to stronger gains.
As Nathan Rothschild famously said, “The time to buy is when there’s blood in the streets.” With the VIX as a guide, traders can navigate through fear and greed, positioning themselves more effectively in the stock market. If you have any questions or feedback, feel free to share them in the comments below!