From the March 01, 2011 issue of Futures Magazine • Subscribe!

Using the VIX to time markets

Ask any floor trader or armchair trading enthusiast if bottoms can be called in the stock market and the responses will range from an enthusiastic “Yes!” to a look as if you just had escaped from a padded room.

This debate is heated between both academics and seasoned practitioners. Careers have been spent studying whether the market can be timed properly and quantitatively to correctly identify a price bottom. Those who endorse holding a diversified portfolio of investments over the long term, like traditional mutual funds, claim market timing doesn’t work. However, seasoned stock traders claim, and demonstrate, that the market can be timed. Well-known pundit Jim Cramer is one. He explains in his book “Real Money” how he calculates a number of variables and, using that data, gains a sense of when price action is about to turn.

The problem for the novice is deciphering how these veterans time the stock market. The inability to quantify this intuition provides naysayers with all the ammunition they need to shoot down market timing; they brand those who practice it — as many see Cramer — as foolish. Our goal is not to debate the track record of pundits, but to provide valuable timing tools. Of course, we know that objective tools do exist. Some of the most popular are oscillators, such as stochastics. However, these tools are not perfect. They only work a portion of the time and only depending on the context of the market.

Using oscillators exclusively and blindly is ineffective because they do not take into account times when the market has a massive selloff. As accelerated selling leads to exaggerated levels in price action, these oscillators show oversold readings for prolonged periods but offer no practical instruction as to when price has reached a point where it will snap back.

The bottom line is that everyone entering or exiting the market is timing it, so one should look to do so at an optimal point. Decades of audited results from professional money managers show it can be done well. The logical foundation for this position can be summed up by three elements: Markets are dynamic because they are made up of individuals, trends form when one crowd takes control and crowds are often wrong.

Markets are made of traders buying and selling. Those who think the market is undervalued, buy; while those who think the market is overvalued, sell. If you get enough traders on either side, they form a crowd that likely will create a trend.

Trends happen when one side takes control of the market. At some point, the crowd that has control will take the market too far in a given direction and this will form extremes in price. When price becomes out-of-balance, it is likely to snap back in the short-term to form a counter-trend.

Finally, most crowds are wrong. This is the paradoxical nature of the markets that is hard to grasp. Professional traders realize that when everyone is buying, that is the time to consider cashing out. Understanding these key concepts is important to timing the market successfully.

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