Market Trends

An Easy Cheat Sheet for Understanding Market Volatility

April 19, 2018

author:

An Easy Cheat Sheet for Understanding Market Volatility

Volatility hasn’t been of much concern for the past five years.

As you can see below, the CBOE Volatility Index (VIX) was tame heading into January.

It was almost too tame…

That isn’t normal!

The VIX measures market volatility by gauging how many put and call options are being bought and sold on stocks in the S&P 500.

Many believe the VIX is a leading indicator… It isn’t.

The VIX is a lagging indicator. It reacts to what is happening in the market… It doesn’t cause things to happen in the market.

But once it rears its head, people begin to use it as a real-time measure of what is going on. That can be effective in the short term, as it is a direct and accurate reflection of the market.

I use the VIX all the time. It is one of the many indicators that allow me to gauge the direction of the market, how fast it’s moving, and how much panic or complacency exists.

And I do know one thing for sure: Complacency can last for a long time. Panic does not.

Get out a notepad and write this down: The sweet spot for the VIX is its historical range, between 15 and 25.

It’s not normal for the VIX to trade below 15 and stay there. The lower it trades, the less normal it is. A reading between 9 and 15 reflects market complacency; it’s a warning sign if it stays there too long.

And if the VIX drops below 9, you should be looking over your shoulder. In the fourth quarter of last year, the VIX traded below 10. A reading that low (or below 9) should really scare the heck out of you. It means investors are a little too relaxed.

In these situations, you should lighten up on stocks. Instead, you should buy puts. That’s because when volatility is low, options are cheaper. As volatillity increases, stock prices will nose-dive and you’ll be able to profit from the market drop.

Back to that notepad… When the VIX is trading above 25, the market is experiencing above-normal volatility. This is when you should start dipping back into the market. It’s also when you should sell options to collect higher premiums.

When the VIX is above 30, we are entering a mini correction. Start buying more stocks and selling more puts. (Just for some perspective, the VIX was trading above 30 during the recent mini correction in February.)

When the VIX moves above 40 – a very rare occurrence – it’s time to accelerate your purchasing.

Finally, when the VIX goes above 50 or 60, it’s time to take out a second mortgage and go all in! The VIX has jumped to levels above 70 just once – during the lows of the 2008 and 2009 correction.

If you were buying then, you would have increased your wealth severalfold in the years ahead. Even putting your money into an index fund would have made you four to five times your initial investment.

Now that you know what levels to look for, how do you “play” the VIX easily?

There are several exchange-traded funds and options that give you exposure.

My favorite is the iPath S&P 500 VIX Short-Term Futures ETN (NYSE: VXX). This is an exchange-traded note (ETN) that should be used for only short-term trading or protection during volatile periods. It is NOT meant to be a long-term holding.

When the VIX starts moving above 15, you can buy shares of this ETN. It will begin to move higher as the market goes lower. At the beginning of the most recent correction in mid-January, the Short-Term Futures ETN was trading as low as $25.50. By the peak of the correction, it was trading above $55.

Since this is a short-term fund, you need to treat it as you would an option. Remember, the time to start selling is when the VIX moves above 30. You should be all out by the time the VIX jumps above 40.

Shares of the Short-Term Futures ETN are easy to trade on any exchange and through any broker. Because the ETN uses futures on the VIX, it will lose value over time as result of “leakage,” meaning new futures must be bought and old futures near expiration must be sold. Therefore, you should never buy this for longer-term protection.

For that, you should buy a longer-term security, which I will share with you next week.

Good investing,

Karim

93 Comments
  1. 601472

    725369

  2. 582672

    122709

  3. 855163

    597757

  4. 193116

    206323

  5. 971939

    862922

  6. 956647

    282856

  7. 300628

    274656

  8. 801917

    521519

  9. 258598

    817252

  10. 474240

    468134

  11. 311289

    900261

  12. 582925

    287323

  13. 298822

    623976

  14. 452875

    908724

  15. 356841

    968746

  16. 513467

    611218

  17. 916729

    672805

  18. 720853

    280145

  19. 581668

    327218

  20. 666247

    765624

  21. 991327

    992914

  22. 205317

    552978

  23. 212431

    592236

  24. 938250

    860854

  25. 253759

    163750

  26. 519920

    860919

  27. 773753

    960899

  28. 887313

    980393

  29. 641992

    997832

  30. 931976

    191618

  31. 263830

    128506

  32. 460336

    215221

  33. 960655

    533660

  34. 793380

    314232

  35. 721947

    654260

  36. 970236

    753183

  37. 620039

    338758

  38. 818165

    190429

  39. 294620

    844343

  40. 756737

    511274

  41. 558953

    934989

  42. 230829

    492579

  43. 178110

    639576

  44. 913974

    439667

  45. 205287

    605275

  46. 306283

    310747

  47. 317862

    599962

  48. 845155

    958607

  49. 646251

    992981

  50. 302750

    482961n56hw3wh7y

  51. 461740

    919035

  52. 566074

    676393

  53. 801010

    193862

  54. 125395

    530907

  55. 393130

    925193

  56. 666970

    816331

  57. 377140

    754903

  58. 279416

    429002

  59. 591056

    712438

  60. 267851

    319735

  61. 832487

    320183

  62. 873737

    381992

  63. 319892

    239207

  64. 815343

    312667

  65. 135043

    722068

  66. 471034

    541198

  67. 516033

    156301

  68. 314822

    420449

  69. 195770

    924449

  70. 832815

    860657

  71. 618298

    144990

  72. 995666

    309118

  73. 790670

    835730

  74. 283979

    934053

  75. 643044

    857419

  76. 272919

    667845

  77. 949726

    970796

  78. 520686

    445406

  79. 189257

    203532

  80. 451704

    606860

  81. 178953

    207214

  82. 775765

    367792

  83. 539598

    486743

  84. 700804

    112430

  85. 951100

    172494

  86. 951100

    n5y5fubhe7

  87. 951100

    dizkobckry2lx064ew5ko0zb42avyo3cv4jw6mub

  88. 121504

    998463

  89. 121504

    8rzi1szumz

  90. 121504

    998463

  91. 121504

    998463

  92. 121504

    n6ugs1gsvaqwc0c9o4ryysvuul0eoio6gy4qrgf5

Leave a comment

Your email address will not be published.