Correlation between price action and VIX

Some background information for new traders about the VIX. A simple Google search has ‘several’ results for the question: “What is the VIX?”

VIX is the ticker symbol for the Chicago Board Options Exchange Market Volatility Index, a popular measure of the implied volatility of S&P 500 index options. Often referred to as the fear index or the fear gauge, it represents one measure of the market’s expectation of stock market volatility over the next 30 day period. The VIX is quoted in percentage points and translates, roughly, to the expected movement in the S&P 500 index over the next 30-day period, which is then annualized. The VIX Index developed by Prof. Dan Galai and Prof. Menachem Brener from Israel, introduced by them to the CBOE at 1987. 6 years later it was introduced in a paper by Prof. Robert Whaley in 1993 while he was at Duke University. Prof. Whaley is now on faculty at Vanderbilt University. ( http://en.wikipedia.org/wiki/VIX )

The VIX is calculated and disseminated in real-time by the Chicago Board Options Exchange. It is a weighted blend of prices for a range of options on the S&P 500 index. The goal is to estimate the implied volatility of the S&P 500 index over the next 30 days.

 

So what does it really mean to your trading?

Here is a chart of the correlation between the daily ATR(3) of the /ES and the VIX.  The /ES is the e-mini S&P 500 futures, btw.  The upper area of the chart shows the VIX overlay on the /ES.   At a basic level you should notice the inverse correlation between the market and the VIX.  VIX goes up, market goes down.  It’s not always the case, but let’s assume the correlation holds for our purposes.

The lower chart is the ATR(3) for the VIX and for the /ES.   Again let’s assume that the ATR(3) increases in both the VIX and the /ES with a degree of correlation worth noting.

 

VIX v /ES- and ATR

 

The next chart shows the /ES on the upper area, just for perspective.  The lower shows the price of the VIX with an overlay of the ATR(3) of the /ES.  If you haven’t guessed as the VIX increases so does the ATR(3) of the /ES.

The chart should tell you that the markets move a larger average amount each day as the VIX increases.   Conversely, the markets move less on average with a lower VIX.

 

 

I trade intra-day price action using range bars, tick charts, and a larger time frame to play with the general trend.   I noticed my stops were being hit much more during higher levels of the VIX and that the swing highs and lows became much larger.  The significantly larger price action swings no longer worked with my standard stop of 2.5 points or less.  Trading in general became much harder with an elevated VIX.

The easiest solution was to reduce contract size and wait for trade setups around key support and resistance levels.  This reduced my % risk to my trading account while forcing me to refine my trading entries.

Think of the market as an engine and the VIX as the throttle, the more you increase the throttle the more vibrations you get.  It is also the case with fear, greed, and price.  Increase fear and risk going forward and price acts wildly.

I like to keep things simple at first to formulate a hypothesis then, if it’s warranted, expand upon my hypothesis.  The VIX is a lot of calculus and voodoo that’s not important to the average trader.  I know that many of the people who do statistical analysis of the VIX and the VIX futures will carry this out in excruciating detail.  They will also calculate correlations and try to estimate volatility.  The correlation is worth noting. So, if you want to do further research there are many articles and research papers at your finger tips with a simple Google search.

So what should you take away from this?  When the VIX is up, try to reduce your risk.

There is one last question to think about: When will I finally get around to telling you the simple secret that will make you the next Warren Buffet?

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