Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

How You Can Profit From 'The Index Of Fear'

As any investor can attest to, things are not always what they seem. Take volatility in the market. It's bad, right?

Not necessarily.

There is an often-misunderstood index that tracks the market's volatility called the VIX. Basically, the index measures the implied volatility of the S&P 500 over the next 30 days.

Sound like mumbo jumbo? Not so fast.

In 2008, I was involved in a fund that included heavy investment in a volatility fund. As the VIX spiked higher in October, I would see the strongest yearly returns in a venture I had ever been part of. It was truly awe-inspiring to witness the power of the VIX in a properly designed portfolio.

You may have heard of this index on CNBC or in the financial press. If you're like me, you may have discounted it as some type of complex indicator for option traders only, with no relevance to the stock market.

Wrong.

Not only does the VIX help project stock movements, it is easy to interpret using a few little tricks.

The VIX was first used in 1993. It's built upon an idea credited to Professor Robert Whaley. The VIX is a weighted blend of prices for a range of options on the S&P 500. The options are based on the expected volatility or price change over the next 30 days. Think of options as an insurance policy. Insurance is priced based on the likelihood of an adverse event occurring.

Simply put, the higher the VIX, the more professional traders believe that stocks will take a downturn. The number of the VIX represents the annualized expected percentage down move of the S&P 500 over the next 30 days. (If you are mathematically inclined, the VIX is calculated as the square root of the par variance swap rate for the next 30 days.) The number has been as low as 9 and as high as 89 during the financial turmoil in 2008.

View it as the S&P 500 upside down. As the VIX moves higher, the S&P 500 moves lower. When the VIX moves lower, the S&P 500 generally travels higher. The VIX is called "the fear index" for a reason. The higher the fears in the market, the more traders hedge their positions with options, driving up the price of the options, therefore the price of the VIX.

Now that you understand what the VIX is, how can an investor put it to work?

Professional traders don't use the VIX as a static number but in relation to its 10-day simple moving average.

Author Larry Connors calls this "the 5% rule." Whenever the VIX is trading 5% below its 10-day simple moving average, the S&P 500 has lost money on a net basis five days following. The opposite has also been extensively tested and proven accurate. Whenever the VIX has been 5% or more above its 10-day simple moving average, the S&P 500 has earned returns better than two to one compared to the average weekly returns of all weeks.

On a relative basis, the VIX is signaling overbought and oversold conditions. In other words, the edge is in buying stocks when the VIX is at least 5% above its 10-day simple moving average. In addition, sell or don't buy stocks when the VIX is at least 5% below its 10-day simple moving average. It's the time-proven, buy-the-fear, sell-the-greed axiom at work in this professional stock trading tactic. 

The Investing Answer: Remember the VIX whenever you are thinking about buying or selling a stock. See where it is in relation to its 10-day simple moving average and use this data to help your decision. 

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