When looking into the stock market's nuances, the term VXX frequently surfaces, often paralleled with the Volatility Index or "Fear Index." Readers must understand that while this article focuses on the VXX, other platforms or brokers might refer to a similar concept as VIX.
This article aims to shed light on the VXX, detailing its importance, operational mechanics, and potential impact on your investment decisions, ensuring a thorough understanding of its role in navigating market volatility.
What is VXX?
The VXX serves as a key market indicator, measuring the anticipated fear and uncertainty in the market through SPX500 options trading. Originating from the Chicago Board Options Exchange (CBOE) in 1993, it has evolved into a widely recognized barometer of market sentiment.
Its calculation hinges on options prices, predicting the expected volatility of the SPX500 index over the forthcoming 30 days. Notably, the VXX (the VIX CFD) exhibits a strong inverse relationship with the SPX500, making it an essential consideration for investment strategies.
How do you calculate the VXX?
It is calculated using the prices of SPX500 options. Specifically, it is based on the prices of options that are near the money and have 30 days until expiration. The formula for calculating the VXX involves finding the implied volatility of these options, which is the expected volatility of the SPX500 over the next 30 days based on the prices of the options.
This calculation is repeated for a range of options, and then the weighted average of these implied volatilities is used to derive the VXX value. The calculation is complex, and it requires specialized software and expertise in options pricing and volatility modeling.
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How to use VXX in trading
- As a hedge: One common use of the VXX is as a hedge against market volatility. If you hold long positions in the market, you can purchase VXX options or futures to protect against a sudden drop in the market.
- As a contrarian indicator: The VXX tends to rise during periods of economic uncertainty and panic. Conversely, when it is low, it can be a sign of complacency and a potential market top for risk assets. Therefore, some traders use it as a contrarian indicator to guide their trading decisions.
- As a market timing tool: Some traders use the VXX to time their market entries and exits. For example, if the VXX is high, it may be a good time to buy stocks at a discounted price. Conversely, if it is low, it may be a good time to sell stocks and take profits.
- As a volatility trading tool: Finally, some traders use the VXX as a tool for trading volatility directly. This can be done through options or futures on the VXX itself, or through other volatility-related instruments. This is a more advanced trading strategy and requires a thorough understanding of options and volatility trading.
Overall, it can be a useful tool for traders, but it should be used in conjunction with other technical and fundamental indicators to make informed trading decisions.
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Why trade the VXX?
- Hedging against market volatility: Let's say you have a portfolio of stocks that you believe will perform well in the long term, but you're concerned about short-term market volatility. By purchasing VXX options or futures contracts, you can protect your portfolio from downside risk.
- Speculative trading opportunities: During times of high volatility, it can spike, providing opportunities for traders to profit from short-term price movements. For example, during the COVID-19 pandemic in early 2020, it hit a record high of 82.69 on March 16th, as global markets tumbled due to uncertainty about the impact of the virus. Traders who bought VXX ETFs or options before the spike could have made significant profits in a short period.
- Market timing: It can also be used to time market entries and exits. For example, if the VXX is high, it may be a good time to buy stocks at a discounted price. Conversely, if it is low, it may be a good time to sell stocks and take profits.
Interpretation of the VXX index
A high VXX reading generally indicates that investors are expecting a high level of volatility in the market over the next 30 days, while a low VXX reading suggests that investors are expecting relatively stable market conditions.
Here are some possible interpretations of different VXX levels:
| S/N | VXX level | Volatility interpretation |
|---|---|---|
| 1. | 0-15 | This is generally a period of calm in the markets, with little expected movement up or down. |
| 2. | 15-20 | This suggests that the market is relatively stable, with only small fluctuations expected over the next 30 days. |
| 3. | 20-30 | This level indicates that investors are expecting some market movement over the next month, but not a significant amount. |
| 4. | 30-40 | This suggests that investors are concerned about market uncertainty and potential downside risk, and are expecting significant price swings over the next 30 days. |
| 5. | Above 40 | This level indicates that investors are very worried about market uncertainty, and are expecting significant price swings and potentially sharp market declines. |
The limitations of the VXX index
It has some limitations when it comes to accurately predicting stock market volatility. One limitation is that it is based on the implied volatility of SPX500 options, which may not always reflect actual market volatility. For example, during the COVID-19 pandemic in early 2020, it spiked to record levels as investors expected high volatility in the stock market. However, the actual volatility in the market exceeded even the elevated expectations reflected in the index.
Another limitation is that it can be influenced by external factors beyond the stock market. For example, Federal Reserve policies and geopolitical events can impact it, even if they do not directly impact the underlying stock market. For instance, if the Federal Reserve announces a change in its monetary policy, it can lead to a spike in the index as investors anticipate how this change may impact the stock market. Similarly, if there is a sudden geopolitical event, such as a terrorist attack or a major political crisis, it can cause it to spike
While the index can be a useful tool for measuring market volatility, it is important to be aware of its limitations and use it in conjunction with other indicators when making investment decisions.
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Instruments most affected by the VXX
- Options: The VXX is calculated based on the prices of SPX500 index options, so it is not surprising that options are the most directly impacted by changes in the VXX. As the VXX increases, the implied volatility of options also increases, making options more expensive.
- Futures: The VXX futures market allows investors to trade on future expectations of market volatility. The prices of VXX futures contracts are closely tied to the VXX index, so changes in the VXX can have a significant impact on VXX futures prices.
- Exchange-traded funds (ETFs): Several ETFs track the VXX (or VVX futures) contracts, such as the iPath SPX500 VVX Short-Term Futures ETN (VXX) and the ProShares VXX Short-Term Futures ETF (VIXY). These ETFs can experience significant price swings in response to changes in the VXX.
- Stocks: The stock market can be impacted by changes in the VXX, as higher volatility can lead to greater uncertainty and risk aversion among investors. This can cause stock prices to decline, particularly for companies with more volatile earnings.
- Credit markets: The VXX can also impact credit markets, such as corporate bonds and credit default swaps. Higher volatility can lead to increased risk aversion among lenders, which can make it more difficult for companies to obtain financing.
Summary
The VXX offers a window into market sentiment and volatility expectations, serving as a pivotal tool for informed trading and investment strategies. Its comparison with the VIX on other platforms highlights the necessity of understanding both terms, especially for those looking to adeptly navigate the financial markets' volatility.
