By Gary Smith
Measuring volatility: using VIX in binary options trading
In many spheres of investing and trading, volatility is something that is often shied away from; the implication being that it implies uncertainty and the inability to make sound decisions. But in essence, volatility is concerned with market movement; binary options traders require this movement in order to make gains (especially on short-term positions) – so the ability to interpret and use volatility to your advantage is essential.
Volatility is concerned with measuring the rate at which prices change. When you are analysing volatility, you are essentially measuring the distance between prices and a calculated mean (i.e. a moving average). Where there is high volatility, prices tend to move faster and further than in market conditions characterised by low volatility.
What is the Volatility Index?
The Volatility Index (VIX) was devised in 1993 by the Chicago Board Options Exchange (CBOE) as a means of measuring 30-day volatility of market prices. A decade later, it was updated to measure volatility based on the S&P 500, the main index for US stocks. Even if you are not trading S&P 500-listed shares, the level of volatility on this index remains relevant because, as an underlying market, this affects many other markets from Forex to commodities. As such, it has come to be regarded as the foremost reliable barometer of global sentiment and volatility.
Identify a specific VIX chart for your particular market
Volatility indices are now widely available for a range of underlying markets. Notable ones include the FTSE 100 VIX, Brent Crude (OVX) and Gold spot (GVZ). Depending on the asset you are taking a position on, it may be that intelligence on likely near-future market activity could be gained by considering several VIX indices. For an equity on an oil corporate with global reach for instance, relevant charts to monitor would certainly be for the stock market where the share is listed – as well as OVX, and possibly also CBOE VIX for an overview of the global climate.
VIX is usually inversely correlated with its underlying market
Volatility is usually at its highest when uncertainty among traders is most prevalent. So in general terms, as fear becomes stronger, the VIX starts to climb – accompanied by an increased likelihood that the underlying market will move downwards (a rising market is viewed as less risky).
For an illustration of this inverse correlation, it’s worth comparing the FTSE 100 VIX and index overview for the weeks following the Brexit: volatility peaked in the immediate run-up to the vote as traders attempted to predict the outcome and decreased markedly as share prices recovered.
How to interpret VIX: spotting sentiment extremes
Implied volatility as shown on a VIX chart is an estimate of the distance that the index will move over a certain timeframe – as set out on an annualised basis. As an illustration, a VIX reading of 17% indicates that over the next 30 day period, the index will move 17% when annualised.
VIX can be at its most useful when attempting to identify sentiment extremes. Again, a useful illustration of this occurred over Brexit. A move to the upper end of the volatility range provided evidence of greater than usual bearishness that foreshadowed a fall. A move to markedly lower than normal levels of volatility on the chart immediately foreshadowed the reversals that occurred.
So although they were not perfect indicators, moves to the extremes on VIX were very useful for anticipating reversals.
So VIX comes into its own primarily as a sentiment indicator. It’s important to monitor it as part of your arsenal of technical analysis tools to confirm or time a position to take.
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