V is For Volatility: Learning to Love the VIX
One of our TradingMarkets Daily Market Bias indicators is
called the VIX Alert. This indicator, like all the indicators in our
Daily Market Bias department, can be used by traders to determine
whether or not there is a directional bias in the next day’s trading. Moreoever,
the VIX Alert also lets traders know whether or not that directional bias is to
the upside or the downside.
The VIX stands for the Volatility Index. The VIX measures
the implied volatility of the S&P 500 options. In language closer to English,
the VIX is one of the more popular indicators used by professional traders to
gauge market sentiment. Is the trading public fearful or complacent? Are
market players more desperate to make money or more terrified of losing money?
The VIX or Volatility Index is an excellent tool to find out.
Writing in his book, How Markets Really Work, Larry
Connors and Conor Sen spend an entire chapter talking about the VIX.
Importantly, they point out that one of the ways that traders have traditionally
used the VIX is, as they put it, “a recipe for disaster.” They continued:
“If there is one truism that we’ve found, it is the fact
that static numbers do not work when it comes to the VIX.”
By “static numbers” Connors and Sen mean specific goalposts
in the level of the VIX that are supposed to automatically trigger trader
action. Connors and Sen illustrate a number of examples in which these static
numbers did not work. Some times, a sell signal based on a static level would
occur, only to have the market continue to move higher. Other times, a buy
signal based on one of these “fixed” points would appear, but the market would
move lower.
How can traders avoid the problem of “fixed” or static
levels when using the VIX?
Connors and Sen discovered that by using dynamic
measurements, a great deal of the VIX’s usefulness was restored. Specifically,
they discovered that by applying moving averages to the VIX, and then studying
the behavior of the market as the VIX moved above and below those moving
averages, a quantifiable edge could be realized. These discoveries led to the
creation of the VIX Alert that is now a part of the TradingMarkets toolkit of
Daily Market Bias Indicators.
So how does the VIX really work for traders? When the VIX
closes 5% or more above its 10-period moving average (usually 10-day moving
average), the market historically has tended to make strong gains. Connors and
Sen learned that this edge was consistent in a number of short-term time frames,
from one- and two-day to one-week.
On the other hand, when the VIX closes 5% or more below its
10-period/day moving average, the markets have tended historically to move
downward or very little at all.
Used alone, this insight into the VIX can be very helpful
for traders. But when used in combination with other indicators — including
the other indicators in our Daily Market Bias department — traders can benefit
tremendously from the advantage of multiple signals confirming each other.
So as we note in our TradingMarkets Rule #5: Use the VIX —
it works, whether you trade ETFs, options or individual stocks. Used correctly,
as Connors and Sen demonstrated, the VIX is one of the best gauges of sentiment
— and likely market direction — that a trader can have.
David Penn is Senior Editor at TradingMarkets.com