[Click on the picture above to find out how you can use the Volatility Index (VIX) to protect yourself from a period of heightened volatility.]
With March quad witching hour out of the way last week, I think it is a good time to have a look at the VIX Index (a calculation of short-term S&P 500 volatility) and consider whether it is time to start buying it in preparation for a return to higher volatility.
Last year in the week after Match quad witching the S&P 500 fell 6.5%. If you look at the last 30 years of returns following March quad witching the average return is negative, so it makes sense to consider whether volatility may pick up in the immediate future.
I show you 30 years of data and explain how I define different periods of market volatility. With the VIX heading below 13, we are nearing crunch time where the market either shifts back into a long period of low volatility as a result of the shift in policy by the US Fed, or we will start to see volatility return and VIX shouldn’t get below 10 from here.
With the VIX costing US$1,000 per point, there is a case to be made that you could start buying VIX the lower it goes and have a stop-loss below nine for example. The risk/reward is starting to favour being long because if markets do turn back down in the near future, we should see VIX heading towards 20 at least and potentially higher.
Traders can also trade the VIX options to gain exposure to heightened volatility, but it should be remembered that VIX options are European options and not American. What that means is that you can only exercise the options on the expiry date. Since VIX is a mean reverting Index that spends short amounts of time at heightened levels before returning to low levels, the price of the options doesn’t move in line with the actual price of VIX.
Traders who don’t understand this fact will be scratching their heads when they aren’t making as much money on the options as they thought they would.
Editor, Alpha Wave Trader
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