Today’s Trading Lesson From TradingMarkets

What Is The VIX?

In my opinion, the VIX is the best
market-timing indicator available for short-term traders today. The VIX is,
simply, a measurement of the implied volatility of the at-the-money OEX Index
Options. High VIX readings usually occur after markets experience sharp
sell-offs, when fear is rampant and sharp reversals to the upside tend to occur.
Low VIX readings (as we are seeing now) usually occur when the market rises.
This is a signal that there is complacency in the market and a sell-off is near.

 

Why Does The VIX
Work?

These four rules will help you
understand why VIX signals work:

1. All
volatility is mean-reverting. This simply means that periods of low
volatility will be followed by periods of high volatility, and vice versa. The
academic world proved this nearly 50 years ago, and it’s one of the few
truisms of market behavior. The reason this is important is that when the VIX
has a high reading and begins to revert to its mean, it’s also accompanied by
a market that begins to rally. Same thing for low VIX readings — when it
begins reverting to its mean, many times it’s accompanied by market sell-offs.
Keep that in mind whenever you’re looking at a VIX chart in the future.

2. Volatility is auto-correlated.
That means if the VIX rises today, it has a better-than-even chance of rising
tomorrow. This is most significant at market extremes
and right before reversals.

3. This is the one that gets most
traders on Wall Street messed up (and if you only learn one thing from this
session, this is the most important): The VIX is
dynamic, not static. Simply saying that you buy the market when the VIX
goes above 30, and sell the market when it trades around 20, is sheer B.S. The
Press over the past couple of years has done a wonderful job of engraining
this into traders’ heads, but nothing could be further from the truth. Blindly
entering the market because the VIX reaches some pre-determined level will
eventually get you killed.

4. As mentioned before, the
VIX measures fear. High VIX means that fear is
high, low VIX readings mean that fear is low. History has proven (and the CVR
signals have statistically proven) that approximately two out of three times,
when these market expectations occur, a top or bottom is in place and we’re
going to look to fade these expectations as we know we will be right
approximately 65% of the time.

CVR Signals

I will now teach you two of my 10 CVR
strategies. Both of these strategies can be found nightly on our

Market Bias page. Also, all the strategies can be found in my book

Trading Connors’ VIX Reversals and in my

nightly service. (Why do I feel like Landry right now, shamelessly plugging
my stuff?)

The 10 CVR signals as a whole over the
past nine years have correctly predicted two- to three-day market direction for
the S&Ps approximately 65% of the time. The CVR 3 and the CVR 7 have correctly
predicted direction nearly 70%. First, let’s look at the CVR 1 signal, which is
the most basic of signals, and then we’ll look at the CVR 3, which is one of my
favorites.

CVR 1 Signal

The rules for the CVR 1 are simple:
For market buys, we are looking for the VIX to make a 5-day high and close under
its open. For sells, we are looking for the VIX to make a 5-day low and close
above its open.

Let’s talk conceptually about what is
going on here. First, a 5-day high or low for the VIX tells us that the market
on a short-term basis may be reaching some extreme. By waiting for it (for buy
signals) to make a 5-day high and then at the same time closing below its open
(remember rule #2: Volatility is auto-correlated), we are finding a market that
may be experiencing a sentiment extreme and has a higher-than-average
probability of reversing for the next two to three days.

Take a look at some of the CVR 1 buy
signals that occurred during the month of December and helped us open up this
year. As you can see, it did a good job of identifying swing lows throughout the
month.

The CVR 1 correctly predicts market
direction approximately 59% of the time (one of the lowest of all the CVR
signals), but more importantly, I’m showing it to you for two reasons: one, for
educational purposes to get you to better understand conceptually what is
happening, and two, because the CVR 1 signal, when it’s combined with the CVR 3
signal (and many other signals) tends to increase the percentage of the time
that the signal is correct.

CVR 3 Signal

Now, let’s move on to the CVR 3 signal
and then we’ll talk about entry and exit. My CVR 3 signal was co-created with
Dave Landry. What we found is that when the VIX moved 10% away from its 10-day
moving average, it identified a market that had been “stretched too far” and was
likely to reverse. In fact, over the last nine years, it has correctly predicted
a two- to three-day reversal better than 68% of the time.

The rules for the CVR 3 are as
follows:

For Buys:

1. Today, the low of the VIX must be
   above its 10-day moving average.
2. Today, the VIX must close at least
   10% above its 10-day moving average.
3. If rules 1 and 2 are met, buy the
   market on the close.
4. Exit (on the close) the day the VIX
   trades (intraday) below yesterday’s 10-day moving average (reversion to the
   man). Or exit within two to four days.

For Sells:

1. Today, the high of the VIX must be
   below its 10-day moving average.
2. Today, the VIX must close at least
   10% below its 10-day moving average.
3. If rules 1 and 2 are met, sell on
   the close.
4. Exit (on the close) the day the VIX
   trades (intraday) above yesterday’s 10-day moving average (reversion to the
   mean). Or exit within two to four days.

Again, let’s look at this
conceptually. For the VIX to move 10% away from its moving average, the market
must have gone through some extreme one-way move. As we all know, the short-term
moves are nearly always unsustainable, and the best reversals come from them. We
have found that the best way to measure these extremes is with the CVR 3. On
average, a CVR 3 signal occurs about once every two and a half weeks, and we
look to exit within a two- to four-day period of time.

Multiple Signals

Before talking about which markets to
trade and entry and exit, I want to cover one more thing. The CVR signals
perform even better when you have multiple signals all pointed in the same
direction. If you take the signals from our

Market Bias page, you’ll want to see at least two CVR signals pointing in
the same direction. If you take the signals from my

trading service, the ideal time is to wait for three or more signals
pointing in the same direction.

Many traders have their own
market-timing methods, some which are quite good. CVR signals combined with
other internal signals will give further confirmation that those signals have an
edge, and increases the odds that your trade will be successful.

Money Management

One caveat: No matter how sure you are
that the market is going to move in one direction, you need to use protective
stops and proper position size to manage the position. Even if you have a
methodology that’s right 70% of the time, it’s more important to remember that
it’s wrong 30% of the time. The gains take care of themselves, it’s how you
manage that 30% wrong that will ultimately decide how successful you are with
your trading.

Vehicles And
Entries

Now let’s talk about which markets to
trade and how to enter positions. The majority of my testing (and real-world
results) with the CVR signals have been with the S&P futures. This means that
the best way to replicate the results is to trade S&P futures (E-minis) or SPDRs.
For the S&P futures, had you traded one contract for every CVR signal since
1993, you would have earned approximately $1.8 million since this past summer.
THERE IS NO GUARANTEE THIS WILL HAPPEN AGAIN. But
this should give you an idea of the cumulative effects of the CVR signals from
1993 up until recently.

With the SPDRs, you’ll essentially be
looking at the same results (percentage-wise).

Alternative Markets

For those of you who don’t want to
trade SPDRs or trade S&P futures, you should look at the

Market Bias page and the CVR signals to guide you as to what the likely
market direction will be for the next couple of days for the market. One of the
things we have continuously preached on the site from Day 1 (in spite of the
fact that it wasn’t in vogue in 1999) was that we need to trade both sides of
the market to fully take advantage of them. Too many methodologies out there are
“bull-market-only” methodologies (or “bear-market-only”) and all these guys got
killed when the market turned on them. If you’re not trading both sides of the
market, you should strongly consider doing so. Dave Landry (there’s that name
again) wrote an

excellent article on how to short stocks. Also, one of the advantages of
trading SPDRs is that they do not require an up-tick so you can short them
immediately, without worrying about violating the up-tick rule.

CVR Signals And
Options

Probably the biggest edge with the VIX
signals occurs in the options market, and I’ll be the first to say after trading
the CVR signals for nearly six years, I haven’t come anywhere close to taking
advantage of this edge. With that said, again let’s talk about what’s going on
with the CVR signals, conceptually. For example, when a CVR buy signal occurs,
and it is correct, it is correctly predicting price direction and volatility
direction at the same time. It really doesn’t get much better than this for
option traders. There are multiple strategies to take advantage of such signals,
ranging from selling naked puts (not advised, but certainly gives you the
biggest edge) to trading verticals.

Let’s take this one step further: By
selling premium on a CVR buy signal, you will have price exploding on the
underlying (which means your short premium is imploding in your favor), and you
have volatility imploding which is causing further good erosion on your short
position. Plus, because these signals are two to four days in nature, you also
have theta (time) working in your favor. Again, it doesn’t get much better than
this.

Let’s go to a CVR sell signal. The
correct strategy here is to be long put premium. The reason is that when the
signal is correct, price will move in your favor, increasing the value of your
put, plus volatility is also moving in your favor, increasing the value of your
put.

As with all these strategies, you want
to be in the market approximately two to four days, and you’ll want to make sure
you use the correct stops to protect yourself when the signals are wrong. As far
as the perfect strategy to trade with this, that is 100% up to you, you’re the
only one who knows what’s best, based upon your trading style and risk
tolerance.

Q&A

Here are some of TradingMarkets
members’ most frequently asked questions on the use of the VIX and CVR signals:

Q:
Do the VIX rules apply to the VXN and QQQ?

A:
I have never really done extensive testing on the VXN.
My initial testing (and my instincts) say that the rules work the same, and
there should be some sort of edge there. I would prefer testing this for at
least a five-year period of time before committing to this any further, but
there should be an edge here.

Q:
What percentage of the time do
multiple signals occur?

A:
Multiple signals occur more often than you think. On
average, when our

Market Bias page has one signal pointing in one direction, about half the
time it will have another one pointing in the same direction. And to reiterate
what I said earlier, the multiple signals do increase the chances of success
with the trade.

Q:
What about the recent low VIX and VXN levels?

A:
As some of you may know from reading

my weekly column or being a subscriber to

my service, the VIX has now spent a good part of the past two months under
its 20-day moving average. The same goes for the VXN. This by itself is not a
signal that the market is going to sell-off immediately, but it does give you a
good heads-up that there is a great deal of complacency in this market.

Another example of this complacency
was Monday night’s action in the VIX. Even though the S&Ps lost nearly 10 points
for the day, the VIX barely budged, and in fact, closed near a four-month low.
Both VIX actions combined were telling you loud and clear that the complacency
out there is at an extreme, and certainly today’s rapid, sharp sell-off occurs
over and over again when these extremes get reached. This is not a 2002 event or
a recent market event; this type of behavior has been exhibited by the
marketplace for decades, and will continue to occur for decades to come.

Q:
What about conflicting signals, meaning one
CVR signal is pointing up and one CVR signal is pointing down?

A:
The answer is simple: PASS THE TRADE. There is no edge here.

Q:
When are the signals on the site updated?

A:
For those of you who are

TradersWire Interactive subscribers, Greg Che comes on the Wire a few
minutes before the close and gives you the signals that look like they will
likely trigger at the close. On the TradingMarkets site and on

my subscription service, the signals are updated nightly at approximately
7:30 p.m. EST.

Q:
What if the CVR signals conflict with the
other Market Bias indicators?

A:
If one CVR signal conflicts with another CVR signal,
you’ll want to pass on the signal. Again, there is no edge. If a CVR signal
conflicts with a TRIN thrust signal, or the momentum index indicator, the CVR
signals override those signals, and the CVR signals should be taken.

Q:
What about specific entry triggers and
stops?

A:
There are two ways to do this:

1. You can anticipate the CVR signals
   occurring and enter the market intraday. This would be especially true by
   placing stops at some level away from the market which will only get triggered
   if the market strongly reverses intraday. This will many times give you a head
   start to the signals (but is far riskier than a mechanical market on close
   entry when you know the signals will be there for sure).
2. Simply to wait for the signal to
   occur, and then enter either on the futures at the close, or for stocks, on
   the market opening the next day.

Another aspect to consider is the exit
strategy. In my book

Trading Connors VIX Reversals, we show two- and three-day
mechanical exits, and the results speak for themselves. For many traders, this
works fine; for me it does not. I’m much too hands-on. I need to be moving my
stops and adjusting my positions appropriately when I can. Again, this is a
personal choice. The most important thing is to use the CVR signals to gain an
edge, and then take advantage of that edge.

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