How to leverage fear with confidence

July 31, 2013 07:00 PM

Stock market volatility is synonymous to the changing of the seasons where summer follows spring, fall follows summer, winter follows fall. This cycle is repeated over and over like clockwork. Volatility in the market also goes through periods of boom and bust. Periods of vigorous price changes are interspersed with those of relative calm. 

The stock market is in a constant state of flux, when one moment it seems that the market is dull and lifeless only to be followed by periods of explosive activity. Often, traders are caught off-guard. By the time they regain their bearings, the opportunity is over. Truthfully, even when the opportunity is recognized, most investors choke and fail to act when the market moves fast. They’re left sitting on the sidelines, afraid to throw their money into the action.

This failure to act can end up costing individual investors dearly. A 2011 study from Dalbar, a Boston-based research firm, estimated that stock investors as a group achieved a meager 3.8% annual return from Dec. 31, 1990, to Dec. 31, 2010, vs. the market’s 9.1% annual average return over that period.

The reason is over that 20-year period, investors jumped in and out of the market at the worst moments. When they should have been buying, they sold out of fear. When they should have been selling, they bought out of greed. The lesson is that your emotions can work against you. If you trade with no plan or strategy to capitalize on the days that offer the best chance for returns, you will leave money on the table, or worse, be on the wrong side of the market at the worst time.

Fortunately, traders can rely on an indicator that is highly correlated to stock market volatility — one that is even more accurate at this task than price itself. First, though, we should lay a foundation of understanding, so it will be clear how to profit from its application.

Implied volatility, VIX, fear

Understanding that emotions tend to drive markets to extremes, you’ll want a means to measure those extremes to gain an edge when and where the market is likely to reverse itself. An effective tool for doing this is implied volatility (IV).

IV is the estimated volatility of a security’s price. In general, it increases when the market is bearish and decreases when it is bullish. This is because of the common belief that bearish markets are more risky than bullish ones.

As one of the largest and most-followed indexes, the S&P 500 is a good subject for your IV analysis. The Chicago Board Options Exchange (CBOE) Volatility Index, or VIX, measures the market’s expectations for 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk. (“Fear gauge,” below, charts the VIX.)

To understand how you can trade with this knowledge, re-consider the revelations of the Dalbar study, that investors usually do the wrong thing at the wrong time when fear and greed are in play. When these emotions drive the market, price moves are not based on sound valuations. In the long run, emotions often are wrong, which is why price typically snaps back when it’s driven to extreme levels.

Reversion & the mean

The concept of reversion to the mean is easy to understand. Imagine a rubber band stretched taut. Think of the rubber band as the mean — the average over time, what we consider the normal state of being for the rubber band.

If you pull the center of this stretched rubber band, it will snap back quickly. This snapping back is called “reversion.” It means that the rubber band returned to its original state, or mean. This is what the market often does when it moves away from its established trend or value.

These two terms — mean and reversion — are both in play when the market moves in cycles. Markets, like the rubber band, move from a normal state (the mean) to an abnormal state, then revert back to the mean, often over-correcting, and they repeat this cycle over and over again.

“VIX entries” (below) shows a sample of trade signals on the VIX. Although not all of these entries are successful, they show that with the right filter, the volatility gauge can provide clear direction for trading the overall market.

Filtering the trend

An important part of the puzzle when trading with the VIX is the 10-day simple moving average (SMA) applied to the volatility indicator itself. This will give you a visual representation of the price action at work and provides a key part of our trade trigger (see “Trade filter,” below).

The rules for the setup condition are:

1) When the VIX rises 10% or more than the 10-day SMA, the first condition is set. Next, look for:

2a) The following VIX price bar must reverse and close below the intraday low of the VIX price bar that registered the highest intraday high; 

or

2b) The following VIX price bar is an inside bar that must be followed by a VIX price bar closing beneath its intraday low.

When these conditions have been met, then enter a long position in the SPY exchange-traded fund or the E-mini S&P 500 futures contract.

This method also is useful for trading options. Because it uses volatility as the focal point to time the stock market, you can use volatility strategies to trade the “vega,” or volatility, of the index’s options rather than focus on just price.

Baron Rothschild preached that you need to enter the stock market when there is “blood in the streets,” but that is easier said than done. The market’s volatility is dynamic and ever-changing. A market can decline, but there always is the risk that it can decline further. Investors need a guide. Measuring volatility and using it to time emotional extremes can be that guide. It gives you an edge over the traders and investors that often are wrong.

Billy Williams is a 20-year veteran trader and publisher of www.StockOptionSystem.com, where you can read his commentary and a report on the fundamental keys for the aspiring trader.

About the Author

Billy Williams is a 20-year veteran trader and publisher of www.StockOptionSystem.com, where you can read his commentary and a report on the fundamental keys for the aspiring trader.