Market Volatility and How to Use it for Your Trading Strategy


What is Market Volatility?

Market volatility is defined as the dispersion of returns of an asset or index.

Huh?

Basically, market volatility is how much an asset is expected to move.

Stocks with higher expected volatility are expected to move more drastically and to larger extents than those with lower market volatility.

One of the primary measurements of market volatility is quoted on the VIX.

Let’s talk about this next so we can put market volatility in context, as a measurable variable.

 

Market Volatility for SP500 – VIX

The VIX is a measure for stock market volatility on the largest 500 companies in the United States.

VIX measures the expected 30 day variance of stock prices in the SP500 stock market index.

Market volatility values are expressed in percentages.

Before the Federal Reserve introduced a whopping amount of liquidity into the market (free money) the volatlity used to average around a 20% reading.

In 2017 markets experienced record low volatility, with the SP500 stock market index averaging around 11 on the VIX.

Looking at a weekly chart of market volatility for the SP500 stock market index, we come to a few important realizations about Market Volatility:

  • Market volatility stays quiet, until it breaks higher in very violent fashion
  • Market volatility is itself very volatile
  • Stock market crashes lead to massive surges in volatility
    • 2008: 420% rally in just 70 days
    • 2010: 209% in 28 days
    • 2011: 200% in 42 days
    • 2015: 350% in 28 days
    • 2018: 440% in 42 days

 

Stock Market Volatility - Weekly Chart SP500 Index

Stock Market Volatility – Weekly Chart SP500 Index

But at this point you must be wondering, what does market volatility mean and how do I use it for my trading strategies?

Let’s take a look at that next.

 

Market Volatility Used as a “Fear Index”

When stock market participants and traders expect a period of enhanced “uncertainty”, the VIX increases (market volatility in SP500 stock market index).

In trading the VIX is called the fear index.  This is because market volatility tends to increase the fastest when fear sentiment in the stock market is increasing.

The VIX is the largest quoted index for market volatility by news outlets and most major publications.

Now that you know this fear index trait of market volatility how would you expect it to move against the stock market?

Overall as stock prices increase along with the indices, the overall fear index drops as market volatility drops.

Therefore, stock market prices and market volatility are said to be inversely correlated.

Here is a chart below that shows the relationship between the SP500 stock index and the market volatility index – VIX:

  • The candle chart is the daily price chart of the SP500
  • Red line is the daily market volatility index reading on VIX

 

VIX vs SP500 Price Chart - Inverse Correlation

VIX vs SP500 Price Chart – Inverse Correlation

 

Market Volatility for Dow Jones Industrial Average – VXD

Just like the SP500 stock market index has a market volatility measure, so does the Dow Jones Industrial Average.

The DOW comprises of 30 of the biggest and most established companies in the US.

DOW is not as well diversified as the 500 stocks in the SP500, but it is very often quoted in the financial media.

Here is a chart of market volatility for DOW stocks – symbol “VXD” on tradingview.com:

  • DOW Jones Industrial Average (DOW for short) in candle sticks
  • DOW market volatility in red – symbol VXD
DOW Jones Industrial Average Stock Market Volatility

DOW Jones Industrial Average Stock Market Volatility

 

Market Volatility for Crude Oil – OVX

Crude oil is one of the most volatile assets on a daily basis.

You can track the crude market volatility by using the symbol “OVX” on TradingView and many other platforms.

Daily oil market volatility below:

  • Crude oil prices in candle chart
  • Oil market volatility in red line
  • Notice they are also inversely correlated
Crude Oil Market Volatility

Crude Oil Market Volatility

 

How to Trade Stock Market Volatility

You can trade and speculate on stock market volatility using options on the VIX index.

There are options listed on VIX like any other optionable stock.

Traders can use market volatility to either speculate and make profit when it rises or falls.

Or alternatively, traders with portfolios can choose to hedge their positions and offset any losses resulting in owning stocks by the gains of a long volatility position.

We discussed a trade like this in our past article, and it can be very helpful for you to understand how to trade market volatility.

Read the VIX options trading strategy post here >

 

That’s it for today TRADEPROs – have an awesome day and manage that risk.

 

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The information contained in this post is solely for educational purposes, and does not constitute investment advice. The risk of trading in securities markets can be substantial. You should carefully consider if engaging in such activity is suitable to your own financial situation. TRADEPRO Academy is not responsible for any liabilities arising as a result of your market involvement or individual trade activities.