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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’ve been 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… |
Most traders are all trying to stay ahead of the curve…
Some scour through the latest financial news and company reports to glean insights about the future of a stock or sector. Others use technical indicators on a chart to determine chart patterns and key price levels.
Whatever methods they use, the goal remains the same – to figure out where a stock (or index) might be headed next. And, to capture some of that move…
I like to use something that gives me an even bigger picture of what might lie ahead – the CBOE Volatility Index (VIX). It’s often referred to as the “fear” index.
The VIX can often indicate when the market is heading for a fall. That’s why I check it out every day.
And while most forms of analysis focus on past trends (like historical information and prices), the VIX is forward looking – it gauges what traders are expecting the market will do in the immediate future (next 30 days).
The distinction comes from how it’s constructed…
The VIX measures the volatility of the S&P 500 using index options. The higher the VIX is, the higher the expected volatility will be over the coming month.
Let me explain… when traders think the market will rise, they buy call options. And when traders are becoming nervous about a potential fall, they buy put options.
The more nervous they become about a potential fall, the more they’ll pay for those put options. And that’s what sends the VIX higher.
However, just because traders are nervous and buying put options doesn’t mean that the market will always fall. But it can often become a self-fulfilling prophecy.
That’s because if those same traders are expecting a fall (and buying put options), they’ll also be selling out of their long positions. That can add to the wider selling momentum – sending the broader market lower.
But even if you don’t trade options at all, the VIX can still be useful.
To see what I mean, look at the chart below of the S&P 500 with the VIX overlaying it…
S&P 500 (SPX) with CBOE Volatility Index (VIX)
Source: eSignal
The blue line represents the S&P 500 Index (SPX), and the red line is the CBOE Volatility Index (VIX). Let’s look at the relationship between the two…
You can see that each of the spikes in the VIX has coincided with a fall in the index. That applies to both the larger and smaller moves.
Put simply, when the VIX spikes, we can expect the index to fall. For a trader, this type of information can be crucial…
If volatility is starting to rise, they may delay going long in a stock (or the index). Or, if they’re looking to short a stock (or index), they might use a spike in volatility to help determine when to enter.
However, it’s not only the initial spike in the VIX that traders watch closely…
You’ll notice that these spikes in the VIX are typically only short lived. They often last no more than a few days. It’s what happens after the spike that traders also find helpful.
To see what I mean, check out the action on the chart from May to September…
S&P 500 (SPX) with CBOE Volatility Index (VIX)
Source: eSignal
While SPX initially fell when the VIX spiked, it subsequently went on to rally as the VIX dropped back to its normal range.
So, instead of just using a spike in the VIX as a signal to go short, traders who are bullish on the long-term trend of the market might use the pullback (from a spike in the VIX) as a trigger to go long…
That’s why the VIX can be a useful tool in either market direction.
To be sure, the VIX might not work 100% of the time (nothing does in the markets).
However, it can offer a much broader and deeper understanding of future short-term movements of the market, rather than just relying on fundamental and technical analysis.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict
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