Tonight, I will begin a series of articles on how to use volatility to your
trading advantage.
The most important feature to understanding how to use volatility is that it
is mean-reverting. This means that periods of high volatility are followed by
periods of normal to low volatility and vice-versa. The academic world proved
this more than 40 years ago.
The second essential feature to understanding volatility is that it is auto-
correlated. This means if market volatility drops today, there is a higher
than average chance it will drop tomorrow.
I have found that the single best place to exploit these inherent market
conditions is with the CBOE OEX Volatility Index, known to traders as the VIX.
The VIX measures the implied volatility of the at-the-money options in the
OEX. When traders are complacent and markets are rising, the VIX tends to be
low. When traders are panicked, especially during sharp market declines, the
VIX reaches extreme high levels. The key to all this information is knowing
how to measure what exactly is a “high” level and what exactly is a “low
level”. Then by combining the above inherent market features with these high
and low levels, you can better gauge when markets have made short-term highs
and lows and are likely to reverse.
In Tuesday’s commentary I will show you how to do that.
Markets to watch
Continue to keep your eye on both the real estate index (and their underlying stocks) and the retail stocks. Both are trading at extremely low volatility compared to normal and are poised for large moves.