High Probability Trading: Why (and How) Professional Traders Use the VIX

With markets mixed heading into trading on Monday, traders may find it difficult to spot the sort of edges that provide for quality, high probability trades.

But one of the fascinating things about high probability trading and the research by Connors Research is that it extends beyond the basic notion “buying the selling and selling the buying.” For example, one of the areas in which Larry Connors research has been especially fruitful has been in the CBOE Volatility Index.

As Larry writes in his book, Short Term Trading Strategies That Work (now available at a new, softcover price. Click here to order your copy today.):

“When the market rises and complacency (and usually greed) takes hold. You will see this with lower than average VIX readings and these have historically been the times to lock in gains and even short the market.

Many web sites, books and analysts attempt to use static numbers for the VIX. This is completely incorrect.”

The CBOE Volatility Index or VIX measures the weighted average of the implied volatilities of options on the S&P 500 index. This is used to gauge the potential for future volatility not just for options traders but for traders of stocks, ETFs, futures and other securities.

Typically, traders have used specific numbers – 10, 30, 50 – static numbers, to determine whether or not the VIX had reached an important level to the upside or downside. What Larry Connors’ research has revealed is that what is most important is the VIX’s relationship to itself and its own recent performance, not just a static number picked out of the air.

To this end, Larry encourages traders to look at the VIX in relation to its 10-day moving average. When the VIX becomes especially stretched above its 10-day moving average, historically it has meant that markets were overextended to the downside and that a rally was likely.

Conversely, when the VIX has become especially stretched below its 10-day moving average, it typically has meant that markets were overextended to the upside and that a reversal lower was increasingly likely.

This is the kind of research that traders can use every day as they monitor levels not just in the stock and ETF markets, but in the VIX, as well. Traders can use this information to make short term trades using equity index ETFs like the ^SPY^, specialty ETFs like the ^VXX^, as well as with e-mini index futures, options and even certain stocks.

Over the course of the week, I’ll present some building blocks that traders can use to construct high probability trading strategies and set-ups using the VIX.

With 16 quantified, backtested trading strategies for bull and bear markets alike, Short Term Trading Strategies That Work, is the kind of high probabiilty trading primer that all short term traders should have in their trading libraries. Click here to order your copy today!

David Penn is Editor in Chief at TradingMarkets.com.