Using the VIX to Trade SPY
The volatility index (VIX), also referred to as the fear gauge, is a calculation that is designed to produce a measure of the constant 30-day expected volatility of the U.S. stock market. Many investors use the VIX to determine fear in the market. On the other hand, investors also use the VIX to gauge market sentiment.
Simply put, a higher level of VIX represents a high level of fear in the market and a low level of VIX indicates a high level of confidence in the markets. The VIX typically measures the near-term sentiment by using the options for the current month's expiry and the next month to calculate the VIX.
Options prices (calls and puts) tend to increase when there are higher expectations of volatility and vice-versa. Relative to options, when the VIX is above its average traders prefer to be a seller of options to capitalize on the higher premium; meanwhile, when the VIX is below its average traders prefer to be a buyer of options, as traders seek to purchase below the average price.
The Correlation Between the VIX and SPY
As can be seen from the image below, when the VIX tends to spike, the SPY tends to fall, indicating fear may be rising in the market. In other words, a higher VIX indicates fear, a lower VIX indicates confidence. The VIX is mean reverting, over time it will generally…
