This Week’s Battle Plan
Test Time!
Each year, around
spring time, we take a
test in this column. This year’s test is a four-parter and will
require some deep thinking. OK, everybody, are you ready? Let’s go!
Question 1
You go out and buy yourself a brand-new
golf driver. It’s a beauty, top-of-the-line, and you spare no expense on it. You
proceed to leave the golf store and go to the closest batting cages. You walk
into the batting cages, put a quarter in the machine and as it starts rifling
baseballs at your head at 80 miles/hour, you use your driver as a baseball bat.
After about an hour of this, you have not hit one single ball (but you have
captured the attention of management and all the kids at the cages). The first
question of today’s quiz is: “Does
The Driver Work?”
Question 2
A father, who has not spent as much time as he
should have with his kids, has a birthday. And as a gift, his kids give him a CD
by the rap singer “50 Cent.” The lead song is “In Da Club,” with the lyrics:
Go, go, go,
go
Go, go, go shawty
It’s your birthday
We gon’ party like it’s yo birthday
We gon’ sip Bacardi like it’s your birthday
And you know we don’t give a f***
It’s not your birthday
He thanks his kids for the gift (and it dawns on him for the first time that his
kids are hoodlums) but decides that the CD is better used as boomerang. He goes
to the park and tosses the CD out there, but it doesn’t return to him. He tries
this over and over, but it fails each time. The second question of today’s quiz
is: “Does The CD work?”
Question 3
A guy goes out and buys an expensive boat. And he figures if it moves this
quickly on water, it must work even better on the freeway. And, as he tries to
get it to transport him from his home to work, the boat doesn’t move. Nothing he
can do, makes this boat budge. The third question of today’s quiz is:
“Does the boat work?”
The Answers
If you answered “No” to any of the above questions, go get yourself
another cup of coffee, because your answers are wrong. Yes, the driver works,
yes, the CD (with those great lyrics!) works, and yes, the boat works!
They don’t work when they are used incorrectly. They do work though, when they
are used correctly.
And that leads us to this week’s lesson, which is…
Does The VIX Work?
This question drives me nuts. It seems to come up about once every 3-4 months
and it always comes up when the market has that 1-2 week one-way run and the
VIX gets pushed to extremes. It rarely comes
up during the 70%-80% of the time (the majority of the time) that the market
trades in a swing trading range of somewhat overbought to somewhat oversold and
vice versa. It only comes up in weeks like the past two, when the market rises
for about 10 straight days and the VIX drops during this time. Or when the
market sold off in late January for about a week and a half and the VIX
gradually reaches extremes.
The debate begins to rage, “Does The VIX
Work?” And this debate lasts until the market reverses, something it
always, always, always has done when the VIX gets overextended. It’s one
of the most highly correlated events you can find on Wall Street. Yet the
debate continues. Why? Because just like in the quiz above, most of the people
asking the question do not know how to properly use it.
How Does The VIX
Work?
The answer to this requires more than the
space in one or two columns. I’ve written
a book on it, done a 6-hour
video course on it and I just spent an entire evening covering this topic in
my seminar. But, this week and next, we can get into the guts of the
indicator and this will give you some answers that you can use to apply to your
trading.
What Is The VIX?
Here is the official definition: “The
Chicago Board Options Exchange OEX Volatility Index reflects a market estimate
of future volatility, based on the weighted average of the implied volatilities
of 8 OEX calls & puts (the nearest in & out of the money call & put options from
the 1st and 2nd month expirations).”
What does this really mean? It really means
it measures the amount of fear and complacency in the marketplace. When the
market is unsure of the future, this creates fear and volatility. The more
uncertainty there is, the higher the fear and the higher the VIX. When the
marketplace feels secure and that there is little perceived danger out there,
volatility lessens and the VIX drops.
Going further, the VIX rises when the market drops and the VIX drops when the
markets rise. When things get really crazy (high fear and high volatility) the
VIX usually goes in a one-way direction up. This sometimes (about once every
3-5 months) takes it to an extreme and out pops the “uninformed” who say, “See,
I told you the VIX doesn’t work.” The same happens when the future looks good
and the market rises and the VIX drops. Again, this happens about once every 3-5
months and again, the uninformed tell us the VIX does not work.
Realities
First, I have no clue what they mean when
they say it does not work. What doesn’t work? Buy the market when the VIX hits
30? That was two-years ago theory. Buy it when it hits 40. Well, that worked
fine until it hit 50 last summer. STATIC NUMBERS DO NOT
WORK WITH THE VIX! Never has and it never will. The VIX traded
between 10-13 in 1993-1994. Then it moved up and it has since “normalized” at
around 25 or so. But the number is meaningless!
What does mean something is how the VIX is in relation to its recent
past. And more importantly, how far away it is from its recent past, because
there is one little thing that the “uninformed” fail to take into account. It’s
that “VOLATILITY REVERTS TO ITS MEAN.” High
periods of volatility are followed by low periods of volatility and low periods
of volatility are followed by high periods volatility. I wish I was smart enough
to have come up with this. but I didn’t. It was first proven by the academic
world in the 1950s and it has been proven over and over again! Volatility
reverts to its mean.
That means when the VIX moves away from its
recent past (you can use a moving average, any moving average, to calculate
this), it will likely find its way back to the moving average. That means when
the market sells off and the VIX moves much higher, the market will likely soon
rally and the VIX will fall (revert to its mean). And, the further it moves away
(and giving time for the doubters to begin their questioning of the indicator),
the more likely a snapback — and maybe a very sharp snapback– will occur.
It has almost
always worked that way and it’s about as sure as anything you can depend upon in
your trading. The problem is that if someone does not use the
information correctly, it really doesn’t work. Using it as a static number or
tossing it out because it moves in one direction for 8 or 9 days in a row a few
times a year, gets you to the same point as the guy who is using his new golf
driver as a baseball bat. The tool only works if you use it correctly!
Next week, we’ll discuss in depth using the VIX correctly and how to apply it to
your trading.
What’s Coming Up
- You can now trade live throughout the day with
Dave Floyd. He has opened an intraday live interactive trading room which he
is the moderator. For a free trial,
click here. - Don Miller is doing a live one week e-Mini
trading seminar. His March seminar sold out quickly and this one in mid-May
probably will too (read the
comments from the attendees of that seminar, they’re terrific).
Information on Don’s seminar can be found
here. - Tim Truebenbach is releasing a CD-rom with a
strategy that he uses to lock in gains much quicker on stocks that break out.
If you would like details you can
find them here.
Finale
There are many poor indicators out there, there
are a few good ones and there are a couple which I consider to be great. The VIX
is one of them, but only if it is applied correctly. Next week, we’ll look at a
good few ways to properly apply them to your trading and forever put to rest in
your mind the question, “Does the VIX work?”
Have a great week trading (and I sure as hell hope my kids don’t give me “In Da
Club” for my birthday)!