VIX & VXN measure the implied volatility of the S&P 500 and Nasdaq 100, and provide us with key data for market analysis:
They represent, no more or less, the RISK PRICES that the Market expects into the future, in the short term.
Implied Volatility Is Different from Historical
When financial study texts mention the word Volatility, and explain its value as a measure of risk, they often refer to Historical Volatility.
However, in the past, it is a simple mathematical calculation, belonging to the area of statistical analysis, that measures the dispersion of the performance of a financial asset.
It is very useful to understand how financial assets have worked for any given period, but it tells us nothing about the future.
Implied volatility, on the other hand, is a MARKET PRICE.
It is determined in the options market, as the value of the options rises the higher the expected volatility.
When we trade options, we are looking to the future, so we are interested in forward volatility, not historical volatility.
But no one knows her.
Therefore, when a trader bids a price for an option (for example, on QQQ) they have to estimate QQQ volatility within the timeframe of their trade.
And come to an agreement on that estimate with the seller.
For each trade that is closed in options, there is an IMPLIED VOLATILITY that traders have estimated to agree on their price.
So the options market provides us with valuable information: what is the risk that traders are looking to the future for each traded asset.
VIX – THE IMPLIED VOLATILITY OF THE S&P 500
So important is this fact that since 1993 the Chicago Board Options Exchange calculates and disseminates in real time the VIX, symbol of the CBOE Volatility Index.
The VIX is known as the fear index.
The higher the value that the VIX reaches, the greater the risk that the market expects into the future.
Let’s look at the graphs below, which look like mirrors.
Both correspond to the year 2008, in which the historical record of the VIX was recorded (here it is better appreciated than in the crisis of 2020, which was shorter).
The top chart corresponds to the VIX, the lower one to the S&P 500.
The correlation between the increase in VIX with the market crash is evident.
It is clear why they call it the FEAR INDEX (although sometimes it also rises because of a high demand for calls)
The VIX is calculated based on the market prices of short-term calls and puts (30 days) on the S&P500.
Here you can see how CBOE calculates the VIX (in detail)
VXN – THE IMPLIED VOLATILITY OF THE NASDAQ 100
Several years later, in 2001, the VXN, a symbol of the CBOE Nasdaq Volatility Index, began to spread, which calculates implied volatility in the price of Nasdaq 100 index options.
(To pronounce it more fluently, traders call it VIXEN )
On this site we focus our attention on this index, to analyze our investments in the market through the ETF that best emulates it: QQQ.
VXN allows us to have, minute by minute, a measure of the expected risk in the market on our preferred asset, QQQ.
In the face of variations in VXN, our market monitoring will allow us to establish the opportunity for aggressive or defensive strategies, depending on the risk decreased or increased.
And this is not a variation of the risk that comes from our opinion or the observation of the past.
It is the perception of the market as a whole, about the expected risk for the near future.
That is why we attach crucial importance when designing our investment policy.
You can expand on this information at the following links:
How to use options to manage risks?
What is the Nasdaq 100 and how is it updated?
What is Algorithmic Trading for?
Variations in VXN are used by many professionals to adjust the risk of their QQQ investments.
Similarly, we give them decisive weight in designing aggressive or defensive strategies in our investment policy.
These policies are reflected in algorithms, and were tested for their effectiveness over an extended period of time, in the face of very different market scenarios.
The backtesting results were very positive. These were the average annual yields («Rendimiento Anual Promedio», in spanish) in the period 2007-2018:
( AL 100 is a set of financial algorithms based on the permanent holding of QQQ and the execution of aggressive or defensive strategies with options, based on yields and volatility.)
After backtesting AL 100, we started to publish the transactions that follow the algorithms, and these were the results:
Finally, you may be interested in the following articles: