Can the Synthetic VIX Equation Make You a Better Trader?

I challenge you to stop looking at the VIX everyone else watches and make your own, much more accurate, "Synthetic VIX"!

You know the "Fear Index" that's shown all over the internet and financial TV.

I'm going to prove to you that it is utter bunk, just more jabber from the mouths of people that make a living blowing sounds bites at you.

You don't need the VIX when you can MAKE it yourself.

More...

What's the VIX

The VIX, as you probably know, measures the S&P 500's option premium.

I'm not going to go into all the math, but you can go down a serious rabbit hole if you like.

More or less it measures how much people are freaking out and how much they are willing to pay for downside protection from the stock market.

I've mentioned this before, but it's worth repeating: Options traders are notoriously terrible traders.

Anytime people have the ability to control a lot of money with a little bit; things get ugly fast.

(You can open an options account with just $5,000!)

So a natural thing to do would be to take the opposite side of these traders, right?

When they are paying "too much" for options (mostly puts) you'd take the other side and bet the market will go up:

The old VIX is bunk

Analysis the VIX without normalizing it first is bunk

The problem is what is "too much"?

How do you know the VIX is at the right price to buy the stock market looking for it to rally?

Technical analyst drawing doodles on charts have a field day with this.

They eye-ball the VIX and say things like "The Vix is the highest in years!"

BUY BUY BUY!

Not so fast there cowboy.

They need a bit more rigor in their thought process before I'd listen.

Such as the need to normalize the VIX data-set so you can compare apples to apples.

Just saying "the VIX is high" isn't enough.

How to Make Your Own Synthetic VIX

To make a proper trading system, you need lots of data that's normalized.

Data that has been washed through a computer so you can compare past events to current events without the bias of price.

Then, and only then, can you begin to answer the VIX question.

So how do we normalize the VIX?

Well, you don't even NEED the VIX to get that data. 

Just use the S&P 500 itself.

Check it out: 

What if I plotted:

( ( Highest(close, 21) - low ) / Highest(close, 21) ) 

Suddenly we have a normalized data-set that has price divided out.

NOW we can look for patterns.

The Synthetic VIX is more accurate

Making the VIX yourself is the way to go

My Favorite Synthetic VIX Pattern

My favorite "anomaly" to look for when using the synthetic VIX is a point where the real VIX is up by the synthetic VIX is low.

This means that the terrible options traders are really paying through the nose for puts and that the market may rally soon.

Here's an example:

Synthetic VIX trading system

Options traders are paying too much premium here

Next Time You Hear "The VIX"

Next time you hear the term VIX, I want you to race over to your computer and see what the synthetic VIX is doing, not the real VIX.

You can't glean an edge if you are always comparing apples to oranges, which is what traders are looking at when they look at the non-normalized VIX.

Use the equation above to plot out the data you need to make real choices when it comes to trading the "fear index."

Don't be a chart doodler!

P.S. You should check out my math-based swing trading system (no hunches, gut feelings or guessing).  

Turn off that dang Financial TV and relax!

TradeStation and MultiCharts Code:

Synthetic Vix Indicator

Synthetic Vix Indicator

About the Author

Hello! I'm Kurt the "Relaxed Trader" writing the stuff on this website. Feel free to ask me questions. I love talking to fellow traders that want to use computers to beat the stock market. Shoot me an email: Kurt@relaxedtrader.com

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