Day traders and investors should track multiple parameters alongside
the main charts and instruments that they are trading. While many have
a direct correlation to the underlying asset, some of the indicators could
also have a negative correlation to the item that is being traded. It is
important to understand such tools and find an edge in the market.
The Volatility index is one such tool that can give you an extra
layer of confirmation for trade on both the long and the short side.
But, VIX as a standalone indicator can be confusing and misleading
as well. It is better to use it along with other parameters and setup rules.
The volatility index actually determines the expected volatility
of an index over the next few weeks. The VIX is derived
from a mathematical equation of the puts and the calls.
Thereby the VIX can help determine whether a market is
having bullish sentiment or bearish foresight. If the market
is full of greed the VIX value is considered to be in lower
ranges. If the volatility (in the case of India VIX above 20)
rises sharply, the market is fearful of a crash or a correction.
The reaction to the VIX is often immediate or within a
few weeks. If you track past charts, you may see that
the markets have reacted within a time horizon of a
For option sellers/writers a High volatility factor is always
risky. It is better to stick to situations that have lower
volatility factors and can give more probab9ility of winning.
Profitability depends on a lot of factors when the VIX is high.
The oscillating prices of the option can be difficult to predict
and that may lead to significant drawdown. However, when
the VIX is lower, it becomes a nightmare for option buyers.
The prices of the options can barely move in the desired
direction. So even though the option had been chosen as
per the direction of the trend, the reward might be significantly
lower. In some cases, the double attack of time decay and
the low volatility in the markets can lead to significantly
higher losses for an option buyer.
One can see that the market has a tendency to top out
when VIX hits the lowest lows and the market falls down
when VIX makes newer highs. This negative correlation is
often tracked by hedge funds and big institutions to predict
and use the market forces to their benefit.
One should also keep in mind the important “timings”
of the market. Keep alerts for the opening, closing, and
rollover time frames. The volatility index gets very choppy
during such timeframes and it becomes difficult to trade in
either direction. On occasions where there is a pre-determined
event or an important announcement, the VIX might abnormally
shoot up and hurt the portfolio of the option sellers.
However, there are ways and strategies to hedge certain
volatility moves. One can work with strict risk management
and an understanding of the core concepts of the asset that
is being traded. The chart has all the answers, it's about
the interpretation. Many employ the strategies like straddles or
strangles, as per their interpretation of the volatility
Books like this might help you in this process.
For Habit Creation and stacking
The volatility index is derived from the order book of
the underlying index. The VIX is not the same as the
value of an index and it often depends on other factors
along with the market sentiments. In the case of India
VIX, the method of measurement is through a technique
that is known as the CBOE method.
The first important parameter that is considered is the
time to expiry. This is measured in minutes and is very
crucial for determining the latent volatile on an immediate
basis. Next, a risk-free interest rate is
attributed to the month of expiry in the options.
The forwarded levels of the index are considered for
determining the at-the-money strike prices and this
determines which option will be used for the calculations.
The at-the-money strike level will be just below the forward
tenure future levels. The best bid and ask quotes of the
option at at-the-money option is then used for
There is another statistical choice that is made in case there
is not enough to bid and ask prices in the relevant strikes.
This method is through the “natural cubic spline” in this process
separate volatility calculations are done for near and far
months expiries. In simple words, the best bid and ask
prices of the near and next month contracts are used
for the calculation of the volatility index. One can also
take the relation of VIX oscillation to be related to the
call and put prices of the underlying options. A higher
VIX means that traders are increasing the bid on the
price of puts as compared to calls. More traders are
expecting the market to fall in the near future. On the
other hand, a falling VIX usually means that more traders
are of the opinion that the market will increase in the near
term and then they6 are willing to pay the higher premium
prices for the calls. the idea is to hold the calls for a longer
period of time and make money.
Simple errors in the market can be improved upon and eliminated by following a trading journal.
Another important factor to keep in mind while
tracking the volatility of the market is that the
markets have some specific coping
mechanism.
Markets hate uncertainty and special events
and uncertain stress points lead the VIX to
significantly higher. The sudden spikes in
VIX give the idea to make money in debit strategies.
Traders and investors can benefit from this indicator
which is derived from a lot of back-end calculations.
It is not a typical indicator that gives you buy
sell recommendation by itself. However, it clearly
helps you in gauging where the market wants to be at.
Read more market-related topics here
Options Strategy for both Buyers & Sellers
How to Put Stop Loss Correctly
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