Larry’s note: Welcome to Trading with Larry Benedict, the brand new free daily eletter, designed and written to help you make sense of today’s markets. I’m glad you can join us. My name is Larry Benedict. I’ve been trading the markets for over 30 years. I got my start in 1984, working in the Chicago Board Options Exchange. From there, I moved on to manage my own $800 million hedge fund, where I had 20 profitable years in a row. And, I’m featured in the book Market Wizards, alongside investors like Paul Tudor Jones. But these days, rather than just trading for billionaires, I spend a large part of my time helping regular investors make money from the markets. My goal with these essays is to give you insight on the most interesting areas of the market for traders right now. Let’s get right into it…

It’s been a tough start to the year for many investors…

After some big falls in January – and some mixed earnings results earlier this month – some of the big-tech stocks investors had come to rely on are feeling the heat.

Add in runaway inflation and the prospect of multiple interest rate rises – not to mention the uncertainty around war in the Ukraine – and investors are now scratching their heads…

It may be tempting to focus on each daily rise and fall of the major indices or the never-ending news cycle.

But today I’m here to tell you about an important index that you should watch closely in times like this. It’s called the CBOE S&P 500 Volatility Index (VIX).

We’ve looked at the VIX a number of times, most recently in December.

The VIX can help traders identify an impending change in direction. It typically spikes when the S&P 500 falls.

For example, look at the most recent spike in the VIX below in January (3) where the S&P 500 fell around 10% during that month…

CBOE S&P 500 Volatility Index (VIX)

Source: eSignal

However, while many investors broadly understand this relationship, there’s something they often miss with the VIX…

The chart shows the VIX going back to the start of 2021. From January to September 2021 the overall trend was down. That’s defined by the 50-day moving average (MA – blue line).

Simply put, as the S&P 500 rallied strongly during that time, volatility continued to fall.

However, that long-term trend (50-day MA) in the VIX started to turn around in September. That was when the S&P 500 retraced around 6% – its biggest fall for 2021 (as of that time).

Since that retracement in September, the 50-day MA shows that the VIX has been trending higher…

CBOE S&P 500 Volatility Index (VIX)

Source: eSignal

What also stands out is the relationship between the 50-day MA and the short-term 10-day MA (red line). As volatility decreased throughout 2021, the gap between the two MAs also contracted.

As the VIX transitioned from a downtrend to an uptrend, the MAs criss-crossed each other closely. Then, the 10-day MA began swinging more wildly (and higher) against the 50-day MA. That’s a result of the VIX spiking higher consecutively at ‘1,’ ‘2,’ and ‘3’ on the chart.

And now, with the Fed due to meet in less than a month (and plenty of economic data due out before then), we can expect this higher level of volatility to continue…

While many investors understand that increasing volatility (VIX) means bigger swings in the underlying market – and prepare for more potential changes in direction – what they often miss is something much simpler…

It relates not only to a change of direction, but to the length of time they hold their trades.

Traders might use the VIX to get it right on a change of direction, but often don’t adjust the length of time they expect to hold their trades to account for that change in volatility.

Put simply, they end up trying to hold onto trades in periods of increased volatility (like now) just as they would when volatility is low (like June 2021).

And that means even when they get into a good trade, the market will often (and quickly) reverse on them… changing a good trade into a loss.

That’s why I’ve drastically reduced the holding time for my trades since the VIX began to rally. I know that without doing so, many of my profitable trades this year would have turned into losers.

So when I look at the VIX, I’m looking for more than just a potential change in direction…

I know that when the VIX is on the way up, I’m going to reduce the holding time for my trades.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict

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