Understanding the VIX

Everyone associates volatility and the CBOE Volatility Index (VIX) with options trading, but you need to pay attention to volatility even if you never touch an option. And it has nothing to do with using the VIX as a "fear gauge" to time the market.

As the great Dr. Brett Steenbarger said, "Personality research suggests that each of us, based on our traits, possess different levels of financial risk tolerance. Our risk appetites are expressed in how we size positions, but also in the markets we trade. When markets move from low to high volatility, they become threatening for risk-averse traders. The volatility of markets contributes to volatility of mood because the potential risks and rewards of any given trade change meaningfully."

Volatility levels can and should dictate everything about your trading, from price targets and stop levels to position sizing.

Quite simply, an increase in volatility is tantamount to an increase in trading size. Consider a $50 stock, we'll call it XYZ. Let's say XYZ carries a volatility of 32. We can divide the volatility by the square root of the number of trading days per year (about 252) and approximate the expected range of XYZ in a given day.

Conveniently, the square root of 252 is near 16, so "the market" expects XYZ to have a range of about 2% per day (32 divided by 16), right?

Well, not exactly. We converted the volatility back to a standard deviation, so it's really saying that 68% of all days should fall within that standard deviation. That is, on 68% of all days, XYZ will trade within a 2% range.

But for the purposes of this example, let's just say a 2% move is the daily expectation for XYZ. That, of course, is $1 for a $50 stock.

Now, suppose the volatility of XYZ volatility doubles to 64. Now the market prices in $2 or so moves per day. The risk level of your trading, therefore, has now doubled.

If you maintain the same size position, or day trade with the same quantity as before, you're essentially doubling your exposure. That's only a good thing if you win.

Frankly, I'd say it's a mistake either way. When volatility doubles, you need to halve your position.

Volatility should affect our price parameters for the exact same reason. If you're day or swing trading, you need to widen your price targets commensurate with the lift in volatility lest you give away a good trade too quickly for the new backdrop. Likewise, you need to widen stops so as to avoid getting shaken out too quickly.

For example, if you were trading the SPDR S&P 500 (SPY) and volatility as measured by the VIX rose 50%, then that would imply that the SPY should have about 1.5 times the range it had before the ramp. So it would be vital to adjust accordingly by reducing position sizes and widening targets.