The VIX is the single best indicator to use to guide you in timing your indices and equity trading. From the research created by Connors Research Group. TradingMarkets has more than 16 years of statistical price studies backing this.
First, let’s quickly define the VIX. The Chicago Board Options Exchange SPX Volatility Index (VIX) reflects a market estimate of future volatility, based on the weighted average of the implied volatilities for a wide range of strikes. 1st & 2nd month expirations are used until 8 days from expiration, then the 2nd and 3rd month are used.
When markets are rising the VIX is usually low. When markets are declining the VIX usually rises. Extreme market sell-offs are associated with extreme VIX readings. Many web sites and analysts attempt to use static numbers for the VIX. This is wrong (in the early 2000’s the prevalent wisdom was to buy the market when the VIX rose above 30 and to sell it when it went below 20. This worked for a short while until the VIX went under 20 in March 2003 (triggering the so called sell signal) and over the next two years, the market rose approximately 50% off its lows while the VIX never saw 30 again during that time!
The proper way to use the VIX is to look at where it is today relative to its 10 day simple moving average. The higher it is above the 10 day moving average, the greater the likelihood the market is oversold and a rally is near. On the opposite side, the lower it is below the 10 day moving average, the more the market is overbought and likely to move sideways-to-down in the near future.
The TradingMarkets 5% Rule. If you only follow one market sentiment indicator, it should be the TradingMarkets 5% Rule. The 5% rule states – Do not buy stocks (or the market) anytime the VIX is 5% below its moving average. Why? Because since 1989, the S&P 500 cash market has “lost” money on a net basis 5 days following the times the VIX has been 5% below its 10 day ma. That’s right, in spite of the S&P 500 rising over 300% since 1989, it’s lost money 5 days following the VIX closing 5% or more below its 10 day ma.
The TradingMarkets 5% Rule is also extremely powerful on the buy side. Since 1989, whenever the VIX has been 5% or more above its 10 day ma, the S&P 500 has achieved returns which are better than 2 1/2 to 1 compared to the average weekly returns of all weeks.
What does this mean for you? It means the potential edge lies in buying the market and stocks when the VIX is at least 5% above its 10 day ma, and to lock in gains (and also not buy) when the VIX is 5% or more below its 10 day ma.
You can find many more information on this on our website, in our indicators page, and in “How Markets Really Work” written by Larry Connors and Conor Sen.
If you find these TradingMarkets Rules worthwhile, then take the next step and learn more information about our Swing Trading College. The Swing Trading College is one of the most popular courses we have offered and a variety of traders – from real-world professional money managers to end-of-day part-timers – have taken advantage of our 14-week course to give their short term trading the extra tools – or major overhaul – they need in order to profit in volatile markets. To learn about the Swing Trading College in greater detail, Click Here.
You can also read the next installment in our series: Rule #6 – Reduce Corporate Risk, Trade ETFs, by clicking here.
David Penn is Editor in Chief at TradingMarkets.com.