Does the CBOE Volatility Index (VIX) Affect Financial Markets?

Traders and investors, wishing to predict the movement of markets to make decisions on transactions, use many indicators and indices.

Our earlier studies have described the impact on financial markets of indicators such as indicators of financial stress, forecast inflation and economic uncertainty.

Today we will study the CBOE volatility index (VIX), which is sometimes called the index of fear in the markets.

The VIX Volatility Index (CBOE) is a metric that measures 30-day volatility expectations using a weighted portfolio of options on the S&P 500 stock index.

It was developed by the Chicago Board Options Exchange (CBOE) in 1993 and is calculated using the following formula:

where Ƭ - number of average days in a month (30 days), r - risk-free rate, F - 30-Day S&P 500 forward price, Р(К) и С(К) - prices for puts and calls with strike K and 30 days to maturity.

Analysis of the obtained results

The presence or absence of a relationship between changes in the VIX index and quotes of financial instruments will be determined using the period-in-period correlation coefficient and with forward and backward shifts. When determining the strength of the connection, we will focus on the Chaddock scale:

The results are presented in the diagrams:

Daily timeframe

On the daily timeframe, period-in-period (shift 0), the following connections have been revealed:

• a weak direct relationship between changes in the VIX index and the rates of the USDCAD and USDRUB currency pairs;
• a weak reverse relationship between changes in the VIX index and the rates of the AUDUSD, NZDUSD and USDJPY currency pairs;
• a salient reverse relationship between changes in the VIX index and the S&P 500 index.

Hourly timeframe

On the hourly timeframe with time shifts of 0 and 1, the following connections have been revealed:

• a weak direct relationship between changes in the VIX index and the rates of the USDCAD and USDRUB currency pairs;
• a weak reverse relationship between changes in the VIX index and the rates of the AUDUSD, GBPUSD, NZDUSD currency pairs, as well as the S&P 500 index.

 15 minutes timeframe

On the 15 minutes timeframe with a time shift of 4 periods, the following connections have been revealed:

• a weak direct relationship between changes in the VIX index and the rates of the USDCAD and USDRUB currency pairs;
• a weak reverse relationship between changes in the VIX index and the rates of the AUDUSD, EURUSD, GBPUSD and NZDUSD currency pairs;
• a moderate reverse relationship between changes in the VIX index and the S&P 500 index.

There is no connection between changes in the VIX index and gold.

Note that:

• rates of USDCAD, USDRUB, AUDUSD, GBPUSD and NZDUSD currency pairs change following changes in the VIX index with a delay of 1 hour. This is confirmed by the correlation coefficients on the hourly and 15-minute timeframes
• changes in the S&P 500 index to a greater extent follow changes in the VIX index, especially on the M15 timeframe.

Now let's evaluate the rate of return of strategies for opening trades based on the VIX index, taking into account the identified correlations:

• with the VIX index growth, we sell gold, the S&P 500 index and pairs with the quoted currency USD, we buy pairs with the base currency USD.
• with the VIX index decreasing, we buy gold, the S&P 500 index and pairs with the quoted currency USD, we sell pairs with the base currency USD.

The strategy will be evaluated according to the following criteria:

• The average rate of return reflects the relative change in the quotes of financial instruments in percentage. A positive value of the rate of return indicates the profitability of the strategy, a negative one indicates a loss. 

The average rate of return (R) of a financial instrument is calculated using the formula:

where:

n is the number of trades;

P (%) – the percentage of change in the quote of a financial instrument at the time of fixing a position, is calculated as follows:

for buy positions

P (%) = (position closing price - position opening price) / position opening price * 100%

for sell positions

P (%) = (position opening price - position closing price) / position opening price * 100%

• The total rate of return (TR) is the sum of the profits from all trades. The greater the value of the total rate of return, the greater the profit brought by the signal during its testing period. 

• Maximum drawdown (MaxDD) is the maximum loss in percentage terms from fixing unprofitable trades for the entire testing period. The lower the value of the maximum drawdown, the better the trading signal works.

where:

n – number of trades;

TRn – total rate of return of n trades;

DDn – drawdown at the time of closing the n-th trade;

MaxDD – maximum drawdown.

Let's start with the higher timeframe D1.

Market entry strategy:

We enter the market if the change in the VIX index modulo exceeds the set threshold (p):

• at the opening of the 1st day following the change in the VIX index
• at the opening of the 2nd day following the change in the VIX index
• at the opening of the 3rd day following the change in the VIX index

We exit the market:

• at the close of the 1st day after entering the market
• at the close of the 5th day after entering the market
• at the close of the 10th day after entering the market
• at the close of the 15th day after entering the market
• at the close of the 20th day after entering the market
• at the close of the day when the opposite signal (OS) appears

Values of p parameter:

• 0 (any changes)
• 5% (small changes)
• 10% (medium changes)
• 15% (big changes)

Theoretically, the greater the modulo change in the VIX index, the stronger the expected reaction of financial instruments.

The results with a significant average rate of return (from 0.3%) are presented in the diagrams below. See the appendix for detailed results.

First, let's look at currency pairs.

In this case, a significant rate of return is achieved only with big changes in the VIX index.

So, the strategy is effective in conditions of strong fluctuations in the VIX index with any of the considered market entries and exits 3 and 4 weeks after the entry.

On average, signals of strong fluctuations in the VIX index occur from 5 to 7 times a year.

Let's show the total rate of return (TК) and maximum drawdown (MaxDD) of currency pairs for the best entry-exit combination: 1-20.

Visually, you can see that the strategy works better with the GBPUSD, USDCHF and NZDUSD currency pairs.

Let's move on to gold

We see that the strategy is effective in the conditions of medium fluctuations in the VIX index when entering the market "vice versa" one day later and exiting the market 4 weeks after entry.

In conditions of strong fluctuations in the VIX index, the strategy is effective for any entry into the market “vice versa” and exiting it 4 weeks after entry. The most profitable entry is "vice versa" a day after strong fluctuations in the VIX index.

That is, with growing anxiety in the markets (medium and strong growth of the VIX index), gold does not decrease, but grows. With growing calm in the markets (medium and strong decline in the VIX index), gold decreases.

On average, signals of medium and strong fluctuations in the VIX index occur 20 times a year.

Let's show the total rate of return (TD) and maximum drawdown (MaxDD) of market entries “vice versa” for the best entry-exit combination: 2-20.

It is obvious that with the increase in the threshold of fluctuations of the VIX index, the maximum drawdown of the “vice versa” entry strategy for gold decreases. That is, filtering entries using the threshold for changing the VIX index has made it possible to reduce losses.

Let's take a look at the significant results for the S&P 500 index

As in the case of currency pairs, a significant rate of return is only achieved with big changes in the VIX index.

We can see that the strategy is most effective in conditions of strong fluctuations in the VIX index when entering the market one day later and exiting 3 weeks after entry. The total rate of return in this case is 81%, the maximum drawdown is 67%, the number of trades is 224.

On average, signals of strong fluctuations in the VIX index occur 7 times a year.

Let's evaluate the results of testing the strategy for the hourly timeframe (H1)

Market entry strategy:

We enter the market if the change in the VIX index modulo exceeds the set threshold (p):

• at the opening of the 1st hour following the change in the VIX index
• at the opening of the 2nd hour following the change in the VIX index
• at the opening of the 3rd hour following the change in the VIX index

We exit the market:

• at the close of the 1st hour after entering the market
• at the close of the 2nd hour after entering the market
• at the close of the 4th hour after entering the market
• at the close of the 8th hour after entering the market
• at the close of the 12th hour after entering the market
• at the close of the hour when the opposite signal (OS) appears

Values of p parameter:

• 0 (any fluctuations)
• 1% (weak fluctuations)
• 2% (medium fluctuations)
• 3% (strong fluctuations)

Theoretically, the greater the modulo change in the VIX index, the stronger the expected reaction of financial instruments.

The results with a significant average rate of return (from 0.15%) are presented in the diagrams below. See the appendix for detailed results.

Significant results have been obtained for the S&P 500 index:

So, the significant average rate of return of the entry strategy at the opening of the first hour after the change in the VIX confirms the previously identified reverse relationship with one-hour shift between the changes in the VIX and S&P 500 indices. This means that the VIX index can act as an outpacing by one hour indicator for the S&P 500 index.

The greatest effectiveness of the strategy is achieved at all thresholds of fluctuations of the VIX index and exiting the market with the appearance of the opposite signal.

On average, the VIX index fluctuation signals occur from 13 times a month (strong fluctuations) to 18 times a day (any fluctuations).

The values of total rate of return and maximum drawdown confirm the effectiveness of the strategy for the specified entries and exits:

With an increase in the threshold of fluctuations of the VIX index, the maximum drawdown mainly decreases. This means that filtering entries using the threshold for changing the VIX index allows reducing losses.

Let's evaluate the results of testing the strategy for the 15-minutes timeframe (M15)

Market entry strategy:

We enter the market if the change in the VIX index modulo exceeds the set threshold (p):

• at the opening of the 1st 15-minute candlestick following the change in the VIX index
• at the opening of the 2nd 15-minute candlestick following the change in the VIX index
• at the opening of the 3rd 15-minute candlestick following the change in the VIX index
• at the opening of the 4th 15-minute candlestick following the change in the VIX index
• at the opening of the 5th 15-minute candlestick following the change in the VIX index

We exit the market:

• at the close of the 1st 15-minute candlestick after entering the market
• at the close of the 2nd 15-minute candlestick after entering the market
• at the close of the 4th 15-minute candlestick after entering the market
• at the close of the 8th 15-minute candlestick after entering the market
• at the close of the 15-minute candlestick when the opposite signal appears (PS)

Values of p parameter:

• 0 (any changes),
• 0,5% (small changes),
• 1% (medium changes),
• 1,5% (big changes). 

Theoretically, the greater the modulo change in the VIX index, the stronger the expected reaction of financial instruments.

The results with a significant average rate of return (from 0.1%) are presented in the diagrams below. See the appendix for detailed results.

Significant results have also been obtained for the S&P 500 index:

So, the significant average rate of return of the market entry strategy at the opening of the 4th 15-minute candlestick after the change in the VIX index confirms the previously identified reverse relationship with a shift of 4 periods of 15 minutes between changes in the VIX and S&P 500 indices. This means that the VIX index can act as an outpacing by 60 minutes indicator for the S&P 500 index.

In addition, entries at the opening of the 1st, 2nd and 3rd 15-minute candlesticks and exits at the close of the 4th and 8th 15-minute candlesticks have shown similar significant results. For entering at the opening of the 3rd 15-minute candlestick, exiting at the close of the 2nd 15-minute candlestick is also effective.

On average, the VIX index fluctuation signals occur from 2 (strong fluctuations) to 60 times a day (any fluctuations).

The values of total rate of return and maximum drawdown confirm the effectiveness of the strategy for the specified entries and exits:

With an increase in the threshold of fluctuations of the VIX index, the maximum drawdown mainly decreases. That is, filtering entries using the threshold for changing the VIX index allows reducing losses.

Detailed results are shown in the Appendix:

XLSX (2.95 MB)Does the Cboe Volatility Index (VIX) affect financial markets.xlsx