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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. 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 almost feels as though every day the market hits an all-time high.
That’s welcome news if you’re a buy-and-hold investor. However, our job as traders is to figure out what might happen next… and how to profit in the short term.
Even though nothing is certain when it comes to the market, one thing we do know is that markets don’t go in one direction forever.
But, to bet on the market falling for no other reason than it has rallied for so long, is a low-probability trade.
You need to have something more reliable to help pick a potential change in direction.
Last week, I showed how you can do that by using the Relative Strength Indicator (RSI) to gauge momentum.
Today, I’ll share another useful tool I often use.
However, it’s not a technical indicator like the RSI. It’s the CBOE Volatility Index (VIX) – often referred to as the “fear” index.
To see how it works, I’ve laid the VIX over the S&P 500 (SPX) index in the chart below…
The blue line on the chart is the S&P 500 going back to the start of 2020.
The dramatic selloff in March 2020 was followed by the V-shaped bounce that started off a 17-month rally.
But as you can see, throughout the long rally, there have been plenty of dips along the way.
The red line on the chart is the VIX. The VIX measures the volatility of the S&P 500 using index options. The higher the VIX, the higher the expected volatility.
Now, it’s important to know that the VIX is still relevant even if you don’t trade options.
When traders think the market will rise, they buy call options. And when they think it will fall, they buy put options.
The more nervous they become that stocks will fall, the more they’ll pay for these put options. This nervousness sends the VIX higher.
As you can see in March 2020, while the SPX quickly fell, the VIX was going through the roof. It has spiked regularly since then, although not to the same level.
Now, pay close attention to what happens when these spikes occur.
You can see that each of the major spikes in the VIX has coincided with a fall in the S&P 500.
Meaning, when the VIX spikes – expect the S&P 500 to fall.
The VIX also offers something else that most indicators don’t…
While technical indicators like the RSI are backward–looking and use historical time and price measures, the VIX is forward–looking. It uses option prices that expire 30 days in the future.
Meaning, it shows you what traders expect to happen… not what the market has done in the past.
That’s why to me, the VIX gives a broader picture of where the market is heading. And that’s why it’s a consistent indicator that I check daily.
For that reason, I’ll continue watching the VIX. It helps me look out for potential trades and allows me to decide whether the market will continue its rally or if it will soon move towards a correction.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict
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