For Forex traders, understanding currencies alone isn’t enough. Because every currency traded in the market acts as a global means of payment, its fluctuations impact many different areas of the economy. In turn, other markets can influence exchange rates, either directly or indirectly. This is why traders need to keep up with political events, economic news, and even the prices of commodities and stocks. The U.S. markets are particularly significant due to their scale and widespread influence.
One key index that traders worldwide follow closely is the VIX, commonly known as the “fear index.” In this article, we’ll explain what the VIX is, how it works, and how it can help currency traders make more informed decisions.
What Is the VIX?
The VIX is an index that measures the expected volatility of the U.S. stock market. In simple terms, it’s an indicator of investor sentiment, reflecting how confident or anxious investors feel about the market’s future.
The calculation process is fairly straightforward. You might be familiar with the S&P 500 index, a widely tracked benchmark for the U.S. stock market. Since the S&P 500 is a tradable asset, there are options on it with varying expiration dates. The VIX is based on options with maturities ranging from 23 to 37 days. The resulting value is then converted into a percentage, indicating traders’ expectations for market volatility over the coming month. The higher the VIX, the less confident investors are about market stability, and vice versa.
The VIX typically has an inverse relationship with stock market performance – when stock prices rise, the VIX tends to fall, and when stocks drop, the VIX often increases. But how does this impact the currency markets?
VIX and Currencies
Even beginner traders understand that major events can shake up exchange rates. In times of uncertainty, investors often choose safer assets over riskier ones. When volatility rises in the markets, investors tend to put their money into “safe-haven” currencies, such as the U.S. dollar, Swiss franc, and Japanese yen. This is why a rise in the VIX often corresponds with an increase in demand for these currencies.
On the other hand, currencies of developing countries with weaker economies are particularly vulnerable during periods of high market volatility. A prime example of this is the Brazilian Real during the 2008-2009 financial crisis, which depreciated by approximately 40%. It is not unexpected that investors tend to divest from unstable assets in times of uncertainty. Consequently, the currencies of developing nations can experience significant devaluation.
When the VIX is low, on the other hand, investors feel more confident about the market outlook. This increased optimism leads to investments in riskier, less stable currencies, causing their values to rise.
To sum up the VIX’s relationship with currency markets:
- Direct correlation with safe-haven currencies: The higher the VIX, the more investors lean toward stable, developed currencies.
- Inverse correlation with currencies from developing economies: Higher VIX levels can lead to depreciation in these currencies.
- Inverse correlation with the EUR/USD pair: Although the euro is a stable currency, during uncertain times, investors tend to favor the U.S. dollar, which can push the EUR/USD pair lower.
Key Points to Consider
It’s important to remember that the VIX reflects investor sentiment and is an economic, not political, indicator. This means that certain world events, while significant, may not always affect the VIX dramatically. For instance, the VIX hit a record high of 89.53 points during the 2008 financial crisis. Another spike occurred in March 2020 with the onset of the COVID-19 pandemic. However, some events, like those of February 2022, had less impact on the VIX despite their global importance.
How Should Traders Use the VIX?
The VIX should not be the sole basis for a trading strategy, as its influence on currency rates is indirect. However, it can serve as a helpful guide, especially for traders who operate on larger time frames and hold positions for several days or weeks.
Here are a few general principles:
- When the VIX rises above 30, it’s worth focusing on safe-haven currencies, which may see increased demand.
- If the VIX exceeds 40 (a rare occurrence), this generally signals widespread panic. In these cases, consider investing in the dollar or pausing your trades until markets calm down.
- When the VIX falls below 20, confidence in the market is higher, and it may be a good time to look into riskier, less stable currency pairs.
In conclusion, remember that the VIX is an auxiliary tool that highlights potential trading opportunities. Before opening any positions, review fundamental indicators and cross-reference with technical analysis. And, of course, always protect your trades with Stop-Loss and Take-Profit orders – especially in high-volatility situations.
