V is For Volatility: Learning to Love the VIX

One of our TradingMarkets Daily Market Bias indicators is called the VIX Alert. This indicator, like all the indicators in our Daily Market Bias department, can be used by traders to determine whether or not there is a directional bias in the next day's trading. Moreoever, the VIX Alert also lets traders know whether or not that directional bias is to the upside or the downside.

The VIX stands for the Volatility Index. The VIX measures the implied volatility of the S&P 500 options. In language closer to English, the VIX is one of the more popular indicators used by professional traders to gauge market sentiment. Is the trading public fearful or complacent? Are market players more desperate to make money or more terrified of losing money? The VIX or Volatility Index is an excellent tool to find out.

Writing in his book, How Markets Really Work, Larry Connors and Conor Sen spend an entire chapter talking about the VIX. Importantly, they point out that one of the ways that traders have traditionally used the VIX is, as they put it, "a recipe for disaster." They continued:

"If there is one truism that we've found, it is the fact that static numbers do not work when it comes to the VIX."

By "static numbers" Connors and Sen mean specific goalposts in the level of the VIX that are supposed to automatically trigger trader action. Connors and Sen illustrate a number of examples in which these static numbers did not work. Some times, a sell signal based on a static level would occur, only to have the market continue to move higher. Other times, a buy signal based on one of these "fixed" points would appear, but the market would move lower.

How can traders avoid the problem of "fixed" or static levels when using the VIX?

Connors and Sen discovered that by using dynamic measurements, a great deal of the VIX's usefulness was restored. Specifically, they discovered that by applying moving averages to the VIX, and then studying the behavior of the market as the VIX moved above and below those moving averages, a quantifiable edge could be realized. These discoveries led to the creation of the VIX Alert that is now a part of the TradingMarkets toolkit of Daily Market Bias Indicators.

So how does the VIX really work for traders? When the VIX closes 5% or more above its 10-period moving average (usually 10-day moving average), the market historically has tended to make strong gains. Connors and Sen learned that this edge was consistent in a number of short-term time frames, from one- and two-day to one-week.

On the other hand, when the VIX closes 5% or more below its 10-period/day moving average, the markets have tended historically to move downward or very little at all.

Used alone, this insight into the VIX can be very helpful for traders. But when used in combination with other indicators -- including the other indicators in our Daily Market Bias department -- traders can benefit tremendously from the advantage of multiple signals confirming each other.

So as we note in our TradingMarkets Rule #5: Use the VIX -- it works, whether you trade ETFs, options or individual stocks. Used correctly, as Connors and Sen demonstrated, the VIX is one of the best gauges of sentiment -- and likely market direction -- that a trader can have.

David Penn is Senior Editor at TradingMarkets.com