The Chicago Board Options Exchange Market Volatility Index (VIX) was designed to gauge the amount of fear among the investors. An increasing VIX number indicates a market where investors are in ‘fear’ mode. In most cases, an increase in volatility leads to a market sell-off while a decrease in volatile leads to normalized situations. Many investors dislike periods of increased volatility while many traders like the increased volatility. This is because with an increased volatility, they can easily enter and exit positions, making huge profits within minutes.
VIX 1 year chart
In the chart above, it is clear that the volatility level is currently in the highest periods this year. This has been fuelled by fears that the Chinese economy is shrinking. In August, the Chinese government devalued its currency to make their exports more competitive in the market. In addition, the government announced that the economy was growing slower than expected. This led to a global market sell off with all sectors feeling the impact. As a result, the amount of volatility in global financial market increased as investors took a cautionary approach because a decline in Chinese growth is risky to the global economy.
Before that, the VIX recorded higher levels in April, May, and June at the heart of the Greece crisis. It is also expected that the index will rise after the interest rate decision by the federal open market commission this month.
Monitoring the VIX
As a day trader, you should make it a habit to having the VIX index always in your screen. It should be the first screen you look at any time before you start trading. Doing this will help you understand the market and also give you a forecast of what to expect. You should compare the trend in the VIX with the price action of the major instruments such as the index future contracts and the dollar index. By comparing the convergence-divergence relationships between the VIX and these instruments is an indicator of what the market will look like during the trading session.
By looking at the charts before a trading session, a number of things can be made. One, a rise in VIX, S&P 500, and the NASDAQ signifies a bearish trend which presents a good opportunity to short the market. Two, an increase in the VIX, a fall in S&P 500 and NASDAQ index futures signals a bearish convergence. Third, a failing VIX, a rising NASDAQ and a rising S&P indicates a bullish trend for the day. Therefore, by having a look at the VIX and comparing it with the key indices and instruments, you will be at a good position to make good decisions during the trading day.
Avoid key asset classes
Volatility in the market is caused by a number of macro factors such as a decline in GDP of key countries such as China. To stay safe during this time, it is important to avoid key assets that have exposure to the said market. For instance, during the Greece crisis, a number of asset classes had direct exposure to the market. The EUR was the first culprit which traders ought to have avoided. In the recent China crisis, traders who went long companies that depend on the Chinese market made significant losses. There are many instruments that investors can buy to protect their portfolios.
Use the Chinese market
5 year chart for: Shanghai composite index,VIX, and S&P 500 and NASDAQ composite
China is the most significant market in today’s financial market. Their markets open and close hours before the United States market open. In many days, what happens in the Chinese market has a direct correlation with what happens when the United States market opens. For instance, if the Chinese stocks fall significantly, it is always expected that the S&P 500, NASDAQ and the DOW will fall. Therefore, as a trader, you can always go short the three if the Asian markets fall and vice versa.
Use the options market
The options market is an attractive way of trading a volatile market. One way of doing this is to buy puts for companies you own or know very well. This will help you protect your money in case of a downside. Using options, you can also initiate a straddle especially when you expect the market to go up or down aggressively.
Market volatility will always be there in the financial world. For day traders, market volatility is your friend. It is during a volatile market that you are able to double or triple your investment capital. By considering the strategies above, you will anticipate the market and place great trades. It does not however caution you from making losses but it will protect you from your account being wiped away.