Why trade the VIX?
Unlike indices, such as the S&P 500 or FTSE, which are groups of company shares, the VIX is a volatility index. The VIX tends to rise with increased market instability. Conversely, if the VIX falls, it signifies stable markets and an increase in the S&P 500.
Traders often use the VIX to hedge their portfolios against market downturns. For example, if you go long on shares in a US company but want to offset potential losses if the market takes a downturn, you would buy the VIX. Taking a long position on the VIX could potentially balance out drawdowns you may experience and hedge your market exposure. Because the VIX exhibits a negative correlation with other asset classes, it can reduce your overall risk and increase returns.
Some traders also speculate on the direction of the VIX itself rather than using it as a hedge. Depending on their outlook for market volatility, they may take long or short positions in VIX futures or options CFDs.
How Volatility trading works
Before you trade the VIX, you need to understand how volatility trading differs from standard CFD trading. Volatility is a measure of the movement of an asset’s price (in this case, the expected movement of the S&P 500 index over the next 30 days) rather than a measure of the price itself. So with volatility trading, rather than focusing on the direction of change, you are speculating on how much the market will move and how frequently that movement will occur.
As mentioned, the VIX and S&P 500 are strongly negatively correlated. That means that when the VIX increases, the S&P 500 is likely falling, and when the VIX falls, the S&P 500 is likely rising.
Going long or going short on the VIX
When you open a position on the VIX, you can either take a long or a short position. If you take a long position, you believe that volatility will increase; if you take a short position, you believe it will decrease. Although there is a strong negative correlation between the VIX and the S&P 500, volatility traders are not interested in whether the price of the S&P 500 will rise or fall, as they can profit from both price movements.
Going long on the VIX
Traders often choose a long position on the VIX during times of financial instability, when there is a lot of uncertainty and fear in the market. For example, if you had taken a long (buy) position on the VIX at the beginning of the Covid pandemic, when it hit 82.7 per cent volatility, you would have made a substantial profit.
Going short on the VIX
Traders take short positions during times of low volatility and generally when they expect the S&P500 to rise in value. Low-interest rates and economic growth usually result in the steady growth of the S&P500’s share prices, so traders short-sell the VIX expecting that volatility will remain low during these conditions. However, it can be risky to short-sell the VIX, as losses can be significant if volatility spikes.
The benefits and risks of trading VIX CFDs
Benefits of Trading VIX CFDs
Trading the VIX allows traders to generate profits from the expected volatility of the S&P 500 index. It also has many other benefits:
- Easy Access and Flexibility: Traders can open an account with a broker and trade on a VIX CFD with a relatively small amount of capital. They can open or close positions anytime during the trading day and choose their trade size.
- Go long or short: You can speculate on VIX price movements in both directions. Traders generally buy (go long on) the index when uncertainty rises in the markets since uncertainty will likely result in heightened fear and greater volatility. Equally, when investors feel confident, volatility will likely decrease, so traders that sell (or go short on) the index may profit.
- Leverage: VIX CFD brokers allow traders to use leverage, which means they can trade with a smaller initial investment than they would need to trade VIX futures or options directly. This can magnify potential returns but also magnify potential losses, so it’s important to use leverage judiciously and manage risk carefully.
- Lower costs: Trading VIX CFDs can be cheaper than trading VIX futures or options, as there are lower transaction fees and no need to pay for margin financing. However, traders should be aware that other costs may be associated with CFD trading, such as overnight swap fees.
- Diverse trading strategies: VIX CFDs can be used in various trading strategies, such as speculating on volatility spikes, hedging against market downturns, or taking advantage of market inefficiencies.
Disadvantages and risks of trading the VIX 75 via CFDs
While there are significant benefits to using CFDs to trade the VIX 75, there are also considerable risks that any trader should be aware of before trading these complex financial products.
- Leverage: When you trade with leverage, you are essentially borrowing money from your broker to increase the size of your position. While this can potentially increase your profits, it also increases your risk of loss. If the market moves against you, your losses can be significantly magnified.
- Constant monitoring: You must always be alert to possible changes in your position. News announcements and other economic events can increase volatility significantly. This may cause rapid price changes that cause the balance of your account to change quickly. This is especially true if you have taken a short position on the VIX.
- It is easy to take on too much risk: Because the cost of trading the VIX is low due to leverage, it is easy for traders to be lulled into a false sense of security and take on higher trading positions than is prudent.
- Limited liquidity: VIX CFDs are less liquid than other financial instruments, such as major currency pairs or stock indices. This can lead to wider bid-ask spreads, slippage, and difficulty executing trades at the desired prices.
The role of CFD brokers in trading the Volatility 75 index
Brokers play a role in facilitating trading on the VIX. They act as intermediaries between traders and the exchange, executing trades on behalf of their clients. The broker provides traders with the platforms, tools, and resources needed to analyse market trends, place trades, and manage their trading accounts.
Brokers also offer traders leverage to benefit from larger trading positions with only a small amount of capital. The broker may provide other services, such as educational resources and customer support.
Important considerations when choosing a broker for trading the Volatility 75 index
When choosing a broker to trade the VIX, there are several important considerations to keep in mind:
- Regulation: You must ensure that the broker is legitimate and trustworthy. Reputable brokers are regulated by financial authorities such as the Financial Sector Conduct Authority (FSCA) in South Africa, the Financial Conduct Authority (FCA) of the UK, the Australian Securities and Investments Commission (ASIC), and the Cyprus Securities and Exchange Commission (CySEC). Check whether your broker has a regulatory licence, and then check with the regulator that the licence is valid.
- Trading Platforms: Traders should choose brokers that offer a variety of stable and user-friendly trading platforms. Trading platforms should provide useful features such as technical indicators, risk management tools, and various charting tools. Third-party platforms, such as MetaTrader 4, MetaTrader 5, and cTrader, are popular among traders because they are available at most brokers, and traders can customise and save their settings should they migrate to another broker.
- Trading Fees: Trading fees include spreads, commissions, and overnight swap fees. Brokers must publish their trading fees on their websites, and traders should choose brokers with competitive spreads and commissions, as these fees can significantly impact profitability.
- Leverage: The broker should offer flexible leverage options for trading the Volatility 75 index. Leverage can magnify profits and increase risks, so traders should choose a leverage level that matches their risk appetite and trading strategy.
- Customer Support: The broker should provide excellent customer support through various channels, including live chat, email, and telephone. Traders should be able to contact the broker at any time and receive prompt and helpful assistance.
- Education and Research: The broker should provide educational resources and research materials to help traders improve their skills and stay informed about market developments. This can include webinars, tutorials, market analysis, and trading signals.
- Deposit and Withdrawals: The broker should offer convenient and secure deposit and withdrawal options, including bank transfers, credit/debit cards, and e-wallets. Traders should also check the broker’s withdrawal policy and processing times.
Using the VIX 75 as a Risk Management Tool
The VIX can also be used as a risk management tool. Because the VIX provides information on levels of implied volatility, it can help determine trade sizes. During periods of higher volatility (high VIX levels), it is prudent to reduce your lot sizes, whereas, during periods of lower volatility (lower VIX levels), you can increase your lot sizes.
Forex Risk Disclaimer
Trading Forex and CFDs is not suitable for all investors as it carries a high degree of risk to your capital: 75-90% of retail investors lose money trading these products. Forex and CFD transactions involve high risk due to the following factors: Leverage, market volatility, slippage arising from a lack of liquidity, inadequate trading knowledge or experience, and a lack of regulatory protection. Traders should not deposit any money that is not considered disposable income. Regardless of how much research you have done or how confident you are in your trade, there is always a substantial risk of loss. (Learn more about these risks from the UK’s regulator, the FCA, or the Australian regulator, ASIC).
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