Calculating the daily expected move of the S&P500 for the month ahead
The VIX is the so-called ‘fear index’ that traders use to evaluate how concerned investors are.
The VIX is an indicator of 30-day implied volatility from the use of S&P500 index options prices. The way it looks is like this. When S&P500 traders sense risk in the markets, they tend to buy put options as a downside insurance policy against longs. The sudden demand for put options causes the implied volatility for both put and call contracts to move higher.
So, what does the VIX tell S&P500 traders about the coming move?
You can use the VIX to calculate larger, 30-day moves, and smaller daily moves. The way to work out the 30-day move for the VIX is by taking the VIX and dividing it by the square root of 12 (we use 12 for each month of the year). So, if the VIX is trading at 20, then we have the following calculation:
20/3.46= 5.78%
So, we know that the current pricing of the VIX is indicating that the S&P500 is expected to have a 5.78% move over the next 30 days. The higher the VIX, the greater the expected move. In this way, you can see what the VIX is saying about the anticipated moves that the S&P500 is likely to see over the coming 30 days. Traders use it as a shorthand for global risk in stocks as the US is so influential in global markets. When the US stocks sneeze, the rest of the world catches a cold.
With around 252 trading days in the year, traders round up the square root of 252 to 16 for the sake of simplicity.
So, how can we use this? Let’s say the VIX is trading at 16. That means that it would be reasonable to expect a 1% daily move in the S&P500. If the VIX was trading at 32, then it would be reasonable to expect a 2% daily move in the S&P500.
Setting expectations
This does not mean that the VIX will move these amounts, but it does give traders a sense of what to expect. This can help set daily targets and stop-losses as you will be aware of the likely volatility of the asset that is being traded. The simple relationship to keep in mind is that as the VIX rises, expectations also rise for stocks to fall. Look at the chart below to see the overlay of the VIX and the S&P500 to see that as the VIX rises the S&P500 falls. The vice versa is also true. A falling VIX and the S&P500 rises. Generally speaking, falling volatility is positive for any underlying asset.
