3 ways to make the volatility index work for you
It's a handy tool that tells you when everyone else is acting crazy.
By Jon Markman
You may have read about the S&P 500 Volatility Index ($VIX) in the aftermath of the fiscal cliff deal.
The so-called "fear index," which moves inverse to the S&P 500, made a record 39% slide downward in just two days.
Now that it's piddling along in a low-fear range, it's time to go along our merry ways and forget about the VIX until the debt ceiling (re)debate next month, right?
Not quite. In the markets, one of the key ways that worry or fear is expressed is through volatility. The VIX is the main measure of the market's expectation of volatility for the next 30 days.
And volatility means big moves to the upside or downside. If you really want to trade successfully in 2013, your surest path is to master volatility.
Here are three ways to put the VIX on your side:
Lean against the crowd when volatility spikes
When volatility is high, even smart investors are prone to mistakes. Take the fiscal cliff. The crisis atmosphere peaked late in the afternoon on Dec. 28, when already-nervous investors issued the market equivalent of a high-pitched scream by pushing the VIX to 23, a level it hadn't seen since the end of May.
People who were working on their individual stock ideas began to think that maybe the fiscal cliff was so important that the lack of a resolution might affect their position. At that point, imagine the heads of everyone in a library looking up from their books to wonder about a commotion that they sense nearby. Now everyone stops acting like individuals and begins to act as a herd. They close their books, and the herd mentality takes over.
Soon, they start walking toward the open door, but because everyone else is doing the same thing, they start running. Think back to our example of Friday, Dec. 28, when everyone started sensing that the fiscal cliff might not be resolved in time. TV pundits were predicting that the Dow Jones Industrials might crash 1,000 points.
Anyone with common sense should realize that is absurd, but fear took over -- and it didn't take much more time before people started selling those stocks -- just in case, you know. I mean, well, everyone else is doing it -- right?
If you had the sense to ignore the crowd, you could have gotten some nice entry prices on stocks that suffered some fiscal cliff panic selling.
Use the VIX as an indicator
Adding the VIX to your toolbox of market indicators is probably the best fit for risk-averse investors. My colleagues at Slingshot Trader have some good explanations about how to track the contango and divergence between the VIX and S&P, and even reading technical charts on the VIX to see what might happen in the overall market.
But there are many other ways to "trade volatility." A host of ETF and ETN products (see InvestorPlace story) are based on the VIX. Funds such as the iPath S&P 500 VIX Short-Term Futures ETN (VXX) amount to "derivatives of derivatives of derivatives." That is, they're derivatives of the VIX, which is in turn a derivative of the implied volatility of S&P 500 index options, which are themselves derivatives of the S&P 500 index.
They don't always move in sync with the VIX, but they can offer additional opportunities to profit from market volatility.
Explore VIX options
Personally, I see VIX options as the best way to profit from the index. Previously, VIX options had been the exclusive domain of elite traders at large institutions. No more. VIX options combine all the qualities I like in an option -- they're liquid, low-priced and they have the potential to provide systematic and consistent wins.
That potential comes from the first two qualities that make VIX options so attractive: their liquidity and low price. A good strategy is to diversify over price and over time. Since VIX options are so liquid and cheap (most trade well under a dollar), you can buy several different strike prices and expiration months to spread out your risk.
However, this strategy is for more risk-tolerant investors -- or for those with a systematic, computerized strategy that takes emotion out of the picture.
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