As we know that on average the VIX declines in value by -0.42% we can factor that into our decision making. Let’s use an example to illustrate this; John is looking for a security he can put $250,000 into and has two options 1. VIX options (a volatility product) or 2. the S&P 500.
VIX options on average lose -0.42% a day and the S&P 500 gains 0.04% a day. Straight away the S&P 500 looks a lot more attractive than the VIX. Although the daily gains in the VIX tend to be a lot bigger, the overall decay will eat away at your profits. So how can traders and investors make money from VIX? By trading VIX options when the prices reach a point considered overvalued.
As we also know that the average price of VIX from 2004 – 2017 is around 18.75 and assume that the VIX price is mean reverting we can determine prices significantly under 18.75 are undervalued and prices significantly over 18.75 are overvalued. This then begs the question, how do you determine what is significantly overvalued and what is not.
In order to see what is overvalued we can look at standard deviations. Standard deviations show how certain data points differ from the mean of those data points. In this case a 1 standard deviation would contain roughly 68% of the data points. 2 standard deviations would contain 95% and 3 standard deviations would contain 99.7%. So from this we know that if prices go into the 2 or 3 standard deviation bracket, we could see the next data points move back into that 1 standard deviation bracket. Please keep in mind though, VIX when it starts to increase in value does so at a phenomenal speed.
Finally, the data on daily VIX highs and daily VIX closes. The reason I have looked at this data is because we know the VIX loses an average of -0.43% a day. As we know it declines each day, it makes sense for us to identify the best opportunities to sell volatility. To do this I have taken a stance that it is better to sell into strength and buy into weakness, or better known as buy low and sell high. In order to find the best time to “sell high” I calculated what each high was on the daily VIX and then what it actually closed at that same day.
The average high to close was -4.465%, this means price got up to a certain level and then declined to close lower. To visualize this I have created a distribution graph.
VIX High to Close Distribution
So from this data you can make the assumption that selling volatility (VIX) is better when trading significantly over 18.75. To aid the selling of volatility you can also consider how much the VIX index is up on that day. If it has significantly increased in value, it would make sense to sell now.