The volatility of the markets is always varying, and depends on how secure or scared the market participants are. Sometimes you want high volatility, such as when you are looking for a large move in a price, and sometimes low volatility will help you sleep better at night, for instance when you look at your long-term investments and savings. It used to be that volatility just was, and you accepted that. Since 1993 however, the Chicago Board Options Exchange has been tracking volatility, and calling the measure of it the VIX.
While it was interesting to see how the volatility varied, it originally was not possible to trade directly on the VIX, which CBOE calculated from the option prices on the market. The VIX is actually the 'implied volatility', that is, it is worked out backwards from the traded prices, and for the VIX it is the prices on the S&P 500 index that matter. The Dow Jones Industrial Average is tracked by a volatility index called the VXD, and the NASDAQ 100 is followed by the VXN.
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The VIX is a percentage, and the higher it is, the more volatile the market is perceived to be. It historically has been between 15 and 35, but it shot up to 90% towards the end of 2008, reflecting the crazy state of the markets. Likewise, last May (2010) the VIX moved sharply up from a level lower than 20 to a high of 45 during the markets sell-off. A good rule of thumb is that values over 30% show a fair amount of investor uncertainty, and values under 20% show investor confidence and even complacency. Where it is in relation to its 10 day moving average has been found significant by Connors Research, who noted that if it was 5% or more above its SMA10, the S&P 500 performed twice as well as average. When 5% or more under the SMA10, the S&P 500 underperformed, at least for the following week.
In addition to futures and options on the VIX which have been introduced, you can now get a contract for difference (CFD) on the value of the VIX, and this represents the best way for many traders who want to take a direct conjecture on the direction that it will move. Some people even suggest that this can be used as a hedge for another existing position. The VIX really acts as if it is negatively correlated to the broad market, so it generally goes up when the market is falling, and falls when the market is increasing - according to the CBOE, this correlation is about 88% true.
Trading volatility is usually limited to short term trading, so it is important to keep abreast of any economic indicators that are to be released during the time frame you intend to trade in. For instance, the USA non-farm payroll figures are widely regarded as one of the most important indicator of how the USA economy is faring, so unexpected numbers here are likely to affect the market and level of volatility.
Two notes about trading CFDs on the VIX. First be aware that volatility is not the equivalent of a downturn in the market and it is very much possible for the market to fall yet volatility remains subdued (although again a Vix reading below 20 has often been followed by a sell-off). This situation would happen if the markets were all moving in one direction and thus nobody is uncertain about what’s going to happen.
Secondly, the VIX is based on the nearest options, and is a 30 day measurement into the future. It does not take account of the longer view, as represented by the options that expire in two+ months. However, as the VIX is continually updated this mitigates the effect of the shorter term, and does allow you to trade on your views of volatility in a longer time frame.
The negative correlation that exists between the stock markets and the VIX index means that investors can either use it as a hedge for their share portfolios or as a way to gain from higher volatility levels. A number of CFD providers offer futures contracts on the Volatility Index, including IG Markets, GFT and CMC Markets, all with fairly competitive spreads. GFT, for instance offer a spread of 0.10 basis points plus the underlying market spread with a margin requirement of just 1 per cent.
You can also trade options directly using CFDs since these are priced in part using implied volatility. To buy an option contract for difference you still have to pay a premium for the privilege (just as if you were buying a regular option) but this premium is the most that you could lose if the trade went against your position. Additionally, the premium cost goes down when volatility is very low so you can use this buy a CFD on a put option, which bets that the FTSE will be at 5,300 by June (at time of writing FTSE is 5,650) for about 100 points. You would thus only need the index to hit 5,200 - hardly unimaginable, - in order to make this trade a profitable one. And should the index end up being volatile but in the wrong direction, then you only lose your premium rather than the unlimited losses that a traditional CFD or spread bet would expose you to.